Banks have played a distinctive role in the financial system for centuries.  In modern times, they are generally first in line for originating loans and in monitoring borrowers.  This is in contrast to public debt, where such close monitoring of a borrower is simply not possible owing to the diverse set of bondholders, which can number several thousands. In a forthcoming Journal of Finance paper by Finance Professor Amar Gande and co-author Anthony Saunders, the nature of banks’ special role is analyzed given a burgeoning secondary market for bank debt. 

From 1991 to 2008, the secondary loan market has grown substantially.  Beyond 2000, secondary loan market transactions have exceeded $100 billion a year. Importantly, according to the authors, the secondary loan market proved resilient during the recent financial crisis, in contrast to the dramatic decline occurred in structured finance products such as commercial loan obligations (CLOs), commercial debt obligations (CDOs) and other securitizations in this class. An active secondary market for loans may have significantly altered the role of banks since banks may not have incentives to hold borrowers’ loans until maturity, and as a result not monitor borrowers to the same extent as they were prior to the existence of the secondary market for bank loans.

About two decades ago, if a bank sold a loan, it was considered negative news for a borrower.  Such a loan sale signaled that the borrower was a ‘lemon’, i.e., a financially troubled entity.  “Not so anymore,” says Gande.

Benefits to banks and borrowers

So what are the implications for banks and borrowers of a rising secondary loan market? There is good news for borrowers. “When a borrower receives a bank loan, there is positive price reaction from the stockmarket,” says Gande. “It is beneficial for the borrowing firm’s equity holders because the lender is watching their back.  That is, the borrower is monitored, and thus it helps shareholders of the borrowing firm.  Furthermore, when the loan trades for the very first time, there is another positive price reaction from the stock market suggesting that the borrowing firm’s shareholders interpret this as good news (rather than as bad news)”. 

This finding of positive news is explained by the fact that banks have limited balance sheets, so they can only originate and hold on their books so many loans. With loan sales no longer having a negative connotation, good news results.  With secondary markets, “banks can use their capital more efficiently by bringing in more capital providers such as hedge funds and other institutional investors that have no skills in origination and monitoring,” suggests Gande.  “With more capital providers and available funds, firms can fund projects they were previously unable to fund because of resource constraints.  Thus many more new projects will be financed, and less underinvestment occurs as the secondary market provides more capital to the borrower.  We find evidence that borrowers whose loans trade in the secondary market in fact obtain larger loans than comparable borrowers whose loans did not trade in the secondary market,” Gande concludes.

Stability and opportunity

In this study the relationship between a bank and a borrower is also analyzed.  The research indicates that after the borrower’s first lead-arranged bank loan is traded on the secondary market, the borrower continues to maintain the relationship with the same bank rather than terminate this relationship.  The lead-arranger bank continues to maintain its borrower-lender relationship even in the presence of a secondary market since it values its banking relationship with the borrower.  This continuation of the borrower-bank relationship post loan-sale reflects this implicit understanding.  

While banks’ “specialness” has changed, i.e., originating loans, monitoring borrowers and the implications attached to this activity—the benefits of a secondary market, added liquidity and risk sharing —trumps any concerns of a slight lessening of banks’ monitoring role.

The secondary market for loans is now almost as large as the bond market, and is a viable alternative for borrowers to raise significant amounts of debt capital.  The bank debt market is vibrant, says Gande.  When asked about why so much capital is still sitting on the sidelines, given these new ways to expand liquidity, Gande suggests: “Banks are simply being conservative and risk-averse.  Additionally, financial players are still learning how to value these risks in a post-recession, financial-crisis world.”

“Are Banks Still Special When There is a Secondary Market for Loans?” by Amar Gande of Southern Methodist University’s Cox School of Business and Anthony Saunders of Stern School of Business, New York University, is forthcoming in Journal of Finance.

Written by Jennifer Warren.