In Syndicated Loans Too Some Are More Equal than Others: The More One Lends, the Higher Returns One Gets

In Why Larger Lenders Obtain Higher Returns: Evidence from Sovereign Syndicated Loans (Financial Management, Summer 2011, volume 40, issue 2, pages 427-453, doi: 10.1111/j.1755-053X.2011.01148.x), Issam Hallak (Department of Finance) and Paul Schure (University of Victoria) show that lenders that lend large amounts earn higher margins than those who lend out smaller amounts. They show this using a dataset of sovereign syndicated loans. In a syndicated loan agreement multiple lenders provide funding to a single borrower (in the dataset of Hallak and Schure the borrowers are sovereign borrowers, such as national governments or central banks). Since all lenders deal with the same borrower in a syndicated loan agreement, the risk per dollar lent is the same across all lenders and the percentage return should also be the same. However Hallak and Schure point out that this is not the case and that larger syndicate members earn more than smaller ones. Lenders receive significant signing fees, which are called upfront fees. These signing fees increase in the amount that lenders fund, even when expressed as a percentage of the funding amount. In their sample of syndicated loans contracted by governments in developing countries between 1982 and 2006, the authors find that the gross percentage return obtained by larger lenders is 8.5% higher than that of the smallest lenders in lending syndicates. Their study investigates what is the source of this striking phenomenon. The results reveal that larger lenders earn higher percentage returns because they are expected to step up in case borrowers end up in a liquidity crisis.

The authors test two hypotheses to explain this feature. The first states that large lenders provide services should the sovereign debtor be unable to repay the debt because of a future liquidity shortage (i.e. liquidity risk). The second hypothesis states that borrowers pay a higher return to larger lenders in an attempt to try to deal with fewer lenders in the syndicate. For instance, a smaller number of lenders could make it easier to renew the loan, or facilitate renegotiations in case additional funding were needed. Hallak and Schure also attempt to test a third hypothesis, namely whether banks are special lenders. One reason that banks could be special is a branch of the literature that shows that the banking sector as a whole tends to attract more deposits in cases of shocks to the financial system. In case of shocks borrowers could be in trouble and the banks could use their extra funds to help them out.

Hallak and Schure adopt a simultaneous equations statistical model. Their analysis rejects the hypothesis that the borrower uses the upfront fee schedule to target a number of lenders. Instead the results show that indicators of borrower's liquidity risk and the distribution of information issues are statistically significant. This is consistent with the hypothesis that large lenders provide services in times of liquidity shortages. They also find that the share of banks among larger lenders results in larger returns for those lenders. This last result is consistent with banks being more capable of providing liquidity services. The authors are yet cautious in the interpretation of the last result as in their sample the average share of banks among large lenders is very high.

The paper is helpful when trying to make sense of the current European sovereign debt crisis, despite of the fact that most of the Euro-denominated sovereign debts are bonds. Several EU governments, including France and Germany, have recently singled out their banks, that is the large holders of Greek debt, to enter in renegotiations. Thus, consistent with Hallak and Schure, the large lenders are currently bearing more than their fair share of the costs associated with the liquidity problems of the Greek government. It is very unlikely, however, that market participants forecasted the possibility of an asymmetric treatment of the large and small lenders when they invested in the Greek debt. For example, the large banks did not ever receive a signing fee. Hallak and Schure would therefore predict that the current state of affairs will probably have a long term effect on the conditions under which banks are willing to invest in future sovereign bond issues.