Managerial ability and bank‐loan pricing

• Published date: 01 October 2017
• Date: 01 October 2017
• Author: Haihao Lu,Gus Franco,Ole‐Kristian Hope
• DOI: http://doi.org/10.1111/jbfa.12267

DOI: 10.1111/jbfa.12267

Managerial ability and bank-loan pricing

Gus De Franco1Ole-Kristian Hope2,3 Haihao Lu4

1FreemanSchool of Business, Tulane University,

NewOrleans, United States

2RotmanSchool of Management, University of

Toronto

3BINorwegian Business School, Oslo, Norway

4Schoolof Accounting and Finance, University of

Waterloo,Waterloo, Canada

Correspondence

Ole-KristianHope, Rotman School of Manage-

ment,University of Toronto and BI Norwegian

BusinessSchool.

Email:okhope@rotman.utoronto.ca

Abstract

This paper examines the impact of borrowers’ managerial ability on

lenders’ bank-loan pricing and the channels through which manage-

rial ability affects bank-loan pricing. Using a large sample of US bank

loans, we provide evidence that higher managerial ability is associ-

ated with lower bank-loan prices. This effect is stronger in firms with

high information risk, suggesting that an important channel for man-

agerial ability to affect bank-loan pricing is through improved finan-

cial disclosure to mitigate information asymmetry. The relationship

is also stronger for firms with weak business fundamentals, imply-

ing that another channel is through improved business performance.

Of these two mechanisms, path analysis suggests that the business-

fundamentals mechanism is the more important channel through

which managerial ability affects bank-loan pricing.

KEYWORDS

bank-loan pricing, disclosure, fundamentals, managerial ability, path

analysis

1INTRODUCTION

Managerial ability is a critical factor in banks’ lending decisions as lenders consistently cite lack of management skill as

the principal reason for loan default (Equinox,2001). Rating agencies, for example, exert significant effort in evaluating

firms’ management when assigning credit ratings, as ‘management strategy,decisions, and policies affect all aspects of

a company’s activity’ (Standard and Poor’s, 2008). Despite the importance of managerial ability in the eyes of lenders

and credit agencies, empirical research investigating whether manager ability affects bank-loan pricing is scant.

Conceptually, managerial ability could affect bank-loan pricing through several mechanisms. For example, high-

ability managers can achieve better firm performance by selecting better projects and implementing them more effi-

ciently. High-ability managers can also provide more reliable financial reports or use other signals to establish cred-

ibility and reduce information risk faced by lenders. This paper empirically investigates whether managerial ability

affects bank-loan pricing by examining15,346 bank loans to non-financial firms. We find that firms with superior man-

agers tend to have a lower cost of debt, controlling for numerous loan and firm characteristics as well as economic

conditions.

Our main proxy for managerial ability isderived from Data-Envelope Analysis (Demerjian, Lev, & McVay,2012). We

recognize that managerial ability is a concept with multiple dimensions, such as operations,strategy, marketing, finance

and risk management. Our primary proxy is essentially an operational efficiency measure. Tomitigate the possibility

J Bus Fin Acc. 2017;44:1315–1337. wileyonlinelibrary.com/journal/jbfa c

2017 John Wiley & Sons Ltd 1315

1316 DE FRANCO ET AL.

that a single proxymay suffer from measurement error, we repeat the analyses employing alternative proxies for man-

agerial ability, such as industry-adjusted ROAand CEO compensation. Following prior literature in debt contracting,

our main measurement for cost of debt is the all-in-drawnspread. Alternatively we use credit ratings and total-cost-of-

borrowing (Berg, Saunders, & Steffen, 2015) to measure cost of debt. Furthermore, we employa change analysis focus-

ing on firms with CEO turnover.We also use simultaneous equations models (Bharath, Dahiya, Saunders, & Srinivasan,

2011), as lenders often determine loan terms simultaneously.Our inferences are robust to these additional tests.

After examiningwhether managerial ability helps reduce the cost of debt, the next question we examine is how man-

agerial ability affects the cost of debt, that is, through what channels is the effect achieved. This issue is important

because understanding the detailed mechanisms helps us learn more about the validity of our observed association.

Economic theory suggests that high-ability managers can use costly mechanisms, such as solid business fundamen-

tals or high-quality disclosures, to achieve better pricing from lenders. Based on information economics, we expect

that when information asymmetry is greater, high-ability borrowers have more incentives to signal their true types

and lenders have more incentives to assess managers’ ability. As a result, we partition samples by the probability of

informed trading (PIN) and abnormal accruals. Consistent with our expectation,we find that the relationship between

managerial ability and cost of debt is more pronounced when borrowers have a high probability of informed trading

or have high abnormal accruals. These findings suggest a disclosure mechanism through which managerial ability can

affect bank-loan pricing.

We also expect the managerial effect to be conditional on firms’ fundamental performance. When lending to a

poorly performing borrower,lenders should have greater incentives to assess the borrower’s quality. Using the Ohlson

O score and operating cash flows as proxies for fundamental performance, we find that the managerial effect is

stronger for high-risk borrowers, suggesting a fundamental mechanism through which managerial ability affects bank-

loan pricing.

Tofurther identify these two mechanisms, we employ path analysis using the same set of proxies for the disclosure

channel and the fundamental channel. We conclude that both channels are supported and that the fundamental chan-

nel is the major mechanism. More than one third of the managerial ability effect is achieved through the fundamen-

tal channel; a smaller portion is through the disclosure channel, and the remaining part is through other un-modeled

channels.

This study contributes to the literature by adding to the emerging research on the determinants of bank-loan con-

tracting.1Toour knowledge, Rahaman and Zaman (2013) is the only other paper that relates managerial ability to the

cost of externaldebt financing. They use the managerial-ability dataset from Bloom and Van Reenen (2007), who exam-

ine 169 mid-size US manufacturing firms on 18 different managerial practices in four categories: operations, monitor-

ing, targets and incentives, and use an aggregate score to represent managerial ability.

Our paper differs from Rahaman and Zaman (2013) in severalways. First, our sample includes a much broader scope

of companies. Specifically,our sample consists of 3,093 firms across industries. Second, our research explicitly tests the

transfer mechanisms through which managerial ability affects bank-loan pricing. We show that managers can signal

their strength by achieving high future cash flows and by making better disclosures, with the former being the more

significant channel.

2LITERATURE REVIEW AND HYPOTHESES DEVELOPMENT

A firm’s management matters to companies and investors. Prior research shows that managers influence firms’ strat-

egy,disclosure policy, as well as operating and financing decisions. For example, Bertrandand Schoar (2003) show that

managers developunique individual-specific styles in operational and financing decisions, and exert idiosyncratic influ-

ence on firms’ corporate decisions.

1Wealso add to research on the economic consequences of managerial ability (e.g., Demerjian, Lev, Lewis, & McVay,2013).