Private Debt Contract Complexity: What the Numbers Don’t Tell You

• In Event: Debt contracting
  In Paper Session: Debt Contracting

Abstract

Empirical research in debt contracting traditionally captures firm and loan risk characteristics with proxies such as size, leverage, credit rating, or the number of covenants. We propose that the private information a borrower provides to its lender, beyond that which resides in the public domain or in credit analysts’ models, may be partially revealed in the contractual features of the loan contract negotiated between lending parties. In particular, this private information may be reflected in the contract’s complexity. Using recent advances from the field of computational linguistics, we attempt to capture proxies for this form of risk and explore its implications on pricing, renegotiation, realized risk, and inter-creditor transfer risk. Incremental to traditionally relied upon summary measures of risk, we find that bank loan contract complexity is strongly associated with initial loan pricing and subsequent loan contract amendments. While we find no relation between contract complexity and secondary market loan trading, we provide some evidence that contract complexity is related to loan downgrades and inter-creditor transfer risk. We therefore provide initial evidence that the contractual features of bank loans partially reveal the private information exchanged between lending parties in the contract negotiation process.

Authors

• Zahn Bozanic, The Ohio State University

• Lin Cheng, The University of Arizona

• Tzachi Zach, The Ohio State University