Banks Write Stricter Loans After Suffering Payment Defaults

Borrowers can expect to receive stricter loan terms not only when they present a risk to their lenders, but also when their lenders are trying to compensate for their own perceived failures in risk management, according to research by Justin Murfin, assistant professor of finance at the Yale School of Management.

Murfin conducted the first study to examine the structure of loan contracts based on the characteristics of the lenders, rather than the borrowers. He found that when banks suffer payment defaults to their loan portfolios, they write stricter loan contracts than their peers.

“A lender who has recently had a really bad quarter is going to write a much stricter loan contract for their borrowers than a lender who didn’t,” says Murfin. “This is true even when their current borrowers are in different industries and geographic areas than their borrowers that defaulted. When a high-tech firm in California defaults on a loan, it can affect the loan contract offered to a mining company in West Virginia if they have the same lender.”

This effect that earlier defaults have on loan terms can be significant. Applying a measure of loan contract strictness that he developed to loan data from DealScan, Murfin found that a one-standard-deviation increase in defaults to a lender’s portfolio induces contract tightening roughly equivalent to what a borrower could expect to receive following a downgrade in its own long-term debt rating.

Murfin also found that banks are much more sensitive to defaults on recent loans than to defaults on older loans. This suggests that banks write stricter loans after recent defaults because they question their ability to screen borrowers.

“As the chief credit officer, I start to worry if I have a large loss to my loan portfolio and my rival banks don’t. Are my loan officers poorly trained? Are my credit models broken? Until I can fix the problem, I want to write much stricter contracts for my borrowers so I can keep them on a tighter leash and renegotiate more frequently.”

According to the findings, the borrowers who are most likely to accept a stricter loan contract when their own risk is unchanged are those with limited options who rely upon a small number of relationship banks and lack access to other sources of capital. The cost to these locked-in borrowers is steep. A one-standard-deviation increase in lender defaults affects their contracts as much as if they experienced two-notch downgrades in their own credit ratings, which is twice that of the full sample of borrowers.

The paper “The Supply-Side Determinants of Loan Contract Strictness” is published in the October issue of the Journal of Finance.

Justin Murfin is an assistant professor of finance. Prior to joining the Yale SOM faculty, he worked for Barclays Capital in New York, Miami, and Bogotá, Colombia.