Bank Compensation for the Penalty-Free Loan Prepayment Option: Theory and Evidence

While it is standard for corporate bonds to include a loan cancellation fee, a surprising 90% of tranche A commercial and industrial term loans allow borrowers to prepay the loan without penalty. We use a simple framework with dynamic learning to derive testable implications for the required bank compensation when including a penalty-free prepayment option. In this framework, after loan origination, borrowers receive noncontractible public information about the value of the project funded by the bank loan. This information causes some ex post high-value borrowers to prepay or renegotiate the loan to obtain a lower rate, deteriorating the credit quality of the bank’s remaining borrower pool. To avoid credit rationing of borrowers with a high prepayment risk, we show that the bank’s compensation must be in the form of an upfront fee rather than a higher initial loan rate, as the latter only exacerbates the adverse prepayment incentive. The model also accounts for the possibility that in relationship lending, an upfront fee may dominate a loan cancellation fee when the latter triggers costly ex post bargaining with high-value clients. To test model predictions, we construct a prepayment risk index, which contains proxies for borrower upside potential and loan renegotiation costs, and we use aggregate industry-level merger and acquisition (M&A) activity as an instrument for exogenous variation in loan prepayment risk. The tests support that upfront fees increase with borrower prepayment risk. In addition, upfront fees are lower for credit lines and loans with performance-sensitive pricing, as predicted. This paper was accepted by Victoria Ivashina, finance. Funding: Partial financial support from Tuck’s Lindenauer Forum for Corporate Governance (Eckbo) and from the Norwegian Research Council [Grant 273678] (Thorburn and Su) is gratefully acknowledged. Supplemental Material: The data files are available at https://doi.org/10.1287/mnsc.2023.00159 .