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Market response to banks granting lines of credit
Journal of Banking & Finance 23 (1999) 1707±1723 www.elsevier.com/locate/econbase
Market response to banks granting lines of credit Michael Mosebach
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Department of Accounting, College of Business and Public Administration, Old Dominion University, Norfolk, VA 23529-0229, USA Received 29 April 1998; accepted 10 February 1999
Abstract Prior research has shown, and this paper con®rms, that when the market becomes aware a line of credit is granted, the borrowerÕs stock has a positive and signi®cant reaction. The borrowerÕs reaction is used to identify the exact date the market becomes aware of the granting of the line of credit. This date is used as a one day window to investigate whether the bankÕs stock also reacts. This reaction will be most obvious with large lines of credit. All lines of credit, larger than US$1 billion, granted during the years 1993±1996 are investigated. The results show, as predicted, a positive and signi®cant reaction by the bankÕs stock. Ó 1999 Elsevier Science B.V. All rights reserved. JEL classi®cation: G21 Keywords: Commercial banking; Lines of credit; Market reaction
1. Introduction This paper investigates the reaction of bank stocks to the announcement that the bank has granted a large line of credit. Existent research shows that the
*
Tel.: +1-757-683-4460; fax: +1-757-683-5639. E-mail address: [email protected] (M. Mosebach)
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announcement generates a positive return for the borrowerÕs stock. This study empirically tests whether the bankÕs stock also reacts. Fama (1985) describes lines of credit as an excellent signaling device that are sometimes used by large companies for no other reason than to signal the market of the companyÕs ®nancial strength. Prior research con®rmed in this study, such as Mikkelson and Partch (1986), ®nds a signi®cant and positive reaction of the borrowerÕs stock to the announcement that a line of credit is granted. James (1987) shows that borrowers experience higher average abnormal returns when banks grant loans than when loans are granted by other lenders. Theoretical work, such as Chemmanur and Fulghieri (1994), empirically con®rmed by Billett et al. (1995) (BFG) indicate that ``more reputable'' lenders provide more new information to the market than ``less reputable'' lenders. BFG also propose that ®rms, in order to send the strongest signal possible, use the best lender available to them. These ®ndings suggest that lines of credit from banks, rather than other lenders, provide the best method of signaling the market. This signal is enhanced as the size of the line of credit increases. It therefore follows that large companies, in order to send the strongest possible signal to the market, use the best bank and largest line of credit available. The current understanding of lines of credit, and other types of loan commitments, is that they are put options. The bank sells the option and, given the competition in the banking industry, collects a fee equal to the present value of the option, therefore, no market reaction is expected. This study agrees that lines of credit are zero net present value transactions for the bank but suggests two related hypotheses consistent with positive market reactions. First, by using the bank, the borrower is signaling the market that they consider it the best lender available to them. Second, new positive information about the bankÕs current and future ®nancial position is transmitted to the market. Data are taken from a unique source consisting of the set of all lines of credit granted by banks during the years 1993±1996 regardless of whether there is a public announcement. This data source eliminates potential selection bias found in past data sets thus adding power to the tests. A more powerful method than used in prior work is also used to identify the event date. The reaction of the borrowerÕs stock is used to identify the exact date the market becomes aware a line of credit is granted. This date is used as a one day event window for the banks further increasing the power of the market reaction tests. The results show a positive and signi®cant market reaction by the bankÕs stock when the bank grants a large line of credit. Therefore, in addition to the signal sent to the market by the bank, a signal is sent to the market about the bank. These ®ndings provide further evidence of the importance of lines of credit as a signaling device. This paper also expands the literature on shareholder wealth eects from internal policy choices made by ®nancial institutions.
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2. Banks and lines of credit A line of credit is a commitment by a bank to loan money at some time in the future. The notional amount is the maximum that can be borrowed under the line of credit. The actual amount and timing of the borrowing is controlled by the borrowers who can draw on the line of credit as often as they like and for any amount as long as the total borrowed does not exceed the notional amount. Lines of credit are an important economic factor in the banking industry. On an average they represent 434% of the bank equity from 1987 to 1992. Lines of credit are also important in a larger economic sense. On 31 March 1998, banks insured by the Federal Deposit Insurance Corporation reported that US corporations held more than US$1280 billion in unused loan commitments and lines of credit. These commitments exceeded the US$820 billion of actual commercial and industrial loans made by US banks. Approximately 80% of commercial and industrial loans made by banks are made under loan commitments and lines of credit are a large portion of loan commitments. When a bank grants a line of credit, it is contractually obligated to lend funds upon demand. Entering into a contract of this nature is a signi®cant economic event for both the bank granting the line of credit and the company being granted the line of credit. Companies use lines of credit for three general reasons. The largest number of lines of credit are issued for operational reasons. Second, lines of credit are used as a good faith gesture to show ability to pay for some speci®c transaction. For instance, the stated purpose of many of the lines of credit investigated for this study is to acquire another company. The line of credit assures the target company that the acquiring company is capable of completing the transaction. This makes the company to be acquired more comfortable disclosing proprietary corporate information. Additionally, Stigum (1990, p. 1033) describes lines of credit as ``insurance premiums'' for commercial paper issuers. Due to the short-term nature of most commercial papers, there is always a risk that the issuer will be unable to roll them over. Therefore, ``...all issuers back their outstanding paper with bank lines of credit... (primarily because)...investors will buy only paper backed by bank lines.'' The above uses of lines of credit have underlying operational purposes. The ®nal reason companies obtain lines of credit is to signal the market. These signals are used to reduce information asymmetries between company management and the market about the companyÕs ®nancial condition. Kane and Malkiel (1965), Bernanke (1983), Fama (1985), and James (1987) all indicate that banks, having virtually unlimited access to corporate information, including past deposit information, are in the unique position of having little or no information asymmetries. Therefore, bankÕs information is perceived as insider information by the market. Thus, when a bank grants a line of credit,
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the market interprets this as a signal from the bank that the company is ®nancially strong, thereby reducing the information asymmetries. Shockley (1995) demonstrates another ®nding signaled to the market. He shows that organizations with unused loan commitments have access to less costly debt. As a result, the borrower, having access to lower cost debt, is in the position of generating higher returns on projects. One indication of the value of this signal is found in Fama (1985): ``...many organizations pay periodic monitoring fees for lines of credit from banks even though they do not take the resources oered. Indeed, large corporations often purchase lines of credit from banks for the sole purpose of providing a signal...'' It should be noted that even when the line of credit is for operating purposes, a signal is still sent to the market. Mikkelson and Partch (1986); James (1987); Lummer and McConnell (1989); Slovin et al. (1992); Best and Zhang (1993), and Preece and Mullineaux (1994) empirically demonstrate the value of this signal by showing that the market reaction of the borrowerÕs stock to the announcement that a line of credit is granted is positive and signi®cant. Additionally, James (1987) ®nds that bank loans provide a larger abnormal return to the borrower than loans made by other institutions. 1 Lummer and McConnell (1989) and Best and Zhang (1993) ®nd a signi®cant dierence between new bank loans and renewals. New loans are made utilizing only information that is already available to the market whereas renewals are made using proprietary information that is acquired from an ongoing relationship. Therefore, a stronger signal is sent at renewal due to the perceived revelation of insider information. This reasoning is supported by the empirical ®ndings of Slovin et al. (1993) who show that replacing an existing banking relationship is costly. In eect, an existing relationship allows a higher quality of monitoring by the lender due to their special knowledge of the borrower. Fama (1985) and Diamond (1991) posit that larger, highly visible borrowers will not bene®t as much from this signal. There are less perceived bene®ts from bank monitoring, because large borrowers are more likely to be monitored by other sources such as analysts, bond rating agencies and the ®nancial press, than smaller and less visible borrowers. This is con®rmed by Slovin et al. (1992) who show that larger borrowers receive smaller abnormal returns than smaller borrowers.
1 Preece and Mullineaux (1994) in a study of short-term loans ®nd no dierence between the various types of lending institutions. Although this contrasts with JamesÕ results, their sample is limited to short-term borrowings, therefore, the results may be unique to that sample or type of loan thus explaining the dierence.
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Chemmanur and Fulghieri (1994) develop a theoretical model that suggests more reputable banks are able to convey more information than less reputable banks. BFG empirically test this proposition and ``...®nd strong evidence that higher quality lenders are associated with signi®cantly higher abnormal returns to borrowerÕs stock, even after controlling for borrower characteristics''. This makes a strong case for the speci®c identity of the lender being an important factor. Work in other areas, Beatty (1989) in auditing and Carter and Manaster (1990) for underwriters, for instance, show that there are reputation eects. The ®ndings in BFG bring the reputation eect into banking. It appears the higher the perceived quality of the agent, be it auditor, underwriter or bank, the more credence the market gives to the information. Therefore, high quality banks are able to signal more reliable information to the market. Large borrowers tend to use banks that are perceived as more reputable. This may explain why there is a signi®cant market reaction by large borrowers that are already tightly monitored by sources other than banks. A strong borrower uses the best signaling device available. Very large companies that use large lines of credit as a signal, therefore, use the most reputable banks available. Merton (1992) indicates that since it is costly to establish or replace a banking relationship, a bankÕs ability to sell its services is enhanced if the market perceives them as being a higher quality bank. It follows that this perception is reinforced if the bank has a large number of strong, high prestige corporate clients. Accordingly, banks will tend to cultivate clients that add to their reputation. Therefore, large strong companies can utilize almost any bank they desire. In addition to the unidirectional eects of the signal, this paper posits that feedback from the borrower about the bank exists. By using the bank, a strong company indicates that it considers the bank an excellent signaling device due to its ®nancial strength and reputation. To eliminate the concern that the lender, in addition to being the best available, may be the only lender available, only large borrowers seeking very large lines of credit are investigated. These large borrowers can use any bank. The market interprets the use of the bank by a strong, high prestige borrower as an indication of the bankÕs strength. There are anecdotal indications that bankers consider it a positive signal when a large borrower uses their bank to obtain a line of credit. Advertisements by First Union Bank found in both Business Week and The Wall Street Journal (WSJ) show prestigious borrowers that have been granted large lines of credit by First Union Bank. For instance, Penske Truck Leasing was granted an US$800,000,000 line of credit by First Union Bank. This was used in First UnionÕs full page advertisement in the WSJ and two page ad in Business Week. In addition to the signal discussed above about the bank from the borrower, this paper also posits that granting a line of credit sends a primary signal to the market about the ®nancial condition of the bank. Assuming lines of credit,
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acting as puts, are correctly priced and competition drives average returns to normal, the market will only react when a line of credit is issued if new information is conveyed. A change in the marketÕs expectations of future cash ¯ows is a necessary condition for an identi®able market reaction to any event. 2 Granting lines of credit is an ongoing function of banks. The market anticipates this much as it would normal sales for any other business. These expectations of the bankÕs performance are impounded into the price of the bankÕs stock. Each announcement is seen as an anticipated sale, therefore, not changing expectations. Alternatively, there is no a priori reason to believe the market is able to anticipate a new and very large line of credit. Thus, very large lines of credit are capable of changing the marketÕs expectation and providing new information. There are several equally plausible ways the market can interpret this signal that will positively change the marketÕs expectations. Granting large lines of credit may signal the market that line of credit activity is higher than expected and the bank is experiencing a short-term positive departure from competitive equilibrium. 3 Any departure from competitive equilibrium leads to a reevaluation of the companyÕs stock by the market. A positive departure such as this leads to an increase in the price of the stock. Megginson et al. (1995) suggest that a bankÕs ability to arrange large loans signals the market that the bank is maintaining its competitiveness. Shockley (1995) describes a related signal sent to the market. He maintains ``...that banks can play an important role in the allocation of credit whether or not they actually fund loans. This is germane given the current debate regarding the relevance of banks, vis-a-vis the capital markets, in the allocation of credit''. A bankÕs ability to arrange large lines of credit, especially for a large, high prestige client, shows the market that not only is the bank maintaining its competitiveness but it is currently, and will be in the future, a signi®cant participant in the allocation of credit. Additionally, it signals the market that the bank is con®dent in its ability to honor any future ®nancial obligation stemming from the exercise of the line of credit. 4 All of these signals lead to positive abnormal returns for bank stocks.
2 Although necessary, it is not a sucient condition because there could be an equal and osetting change in the risk factor which would cause the stock price to remain unchanged, thus there would be no market reaction. 3 The opposite is true for smaller than anticipated activity in lines of credit. ``Smaller than anticipated'' is dicult to quantify and is beyond the scope of this study. 4 One empirical implication is that the signal is more informative to the market for less reputable banks, in that there is more of a surprise, than it is for more reputable banks, leading to a greater market reaction for less reputable banks. In order to test this, a strati®ed sample of banks is required. Due to the homogeneous makeup of the sample in this paper, testing this empirical implication is not possible. Thanks go to an anonymous reviewer for this suggestion.
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Large lines of credit are usually underwritten by more than one bank. One or more banks act as lead or co-lead banks and form a syndication with other participating banks to fund the line. In this study US$1 billion is used as the cut-o for lines of credit. 5 Every line of credit in the sample is syndicated, and considering their size, this is not a surprise. Given that each bank is only committed to a percentage of the large line of credit, lines of credit smaller than US$1 billion may not be large enough to aect signi®cant economic re-evaluation of the bankÕs stock. 6 In most instances, the lead bank or banks have an ongoing relationship with the borrower. Therefore, even though the line of credit itself may be a new transaction, a strong signal is sent to the market due to the existing relationship. It has been shown empirically Lummer and McConnell (1989) and Hull and Moellenberndt (1994) when a line of credit is terminated, a negative signal about the borrower is sent to the market. As a result, borrowers have a strong incentive not to discontinue their lines of credit. Additionally, if the borrower uses the line of credit strictly as a signaling device they cannot discontinue the line of credit without defeating the purpose. An indication of the marketÕs expectation that a line of credit is a perpetuity for the bank is that the maturity is rarely mentioned at the announcement that a line of credit is granted and renewal announcements are rare. Prior research, such as Thakor et al. (1981), also shows that companies are reluctant to change banks. Very large companies change banks so rarely that the probability of them changing banks is essentially zero. 7 If the company is not going to change banks or discontinue its line of credit, the revenue stream from the line of credit should be perceived as persistent. 8 Therefore, large lines of credit, in addition to signaling a positive departure from competitive equilibrium, represent a new and permanent income stream to the bank and can indicate future increases in line of credit and loan activity due to the bank maintaining both its overall competitiveness and its position in the allocation of credit.
5 By limiting the lines of credit to those over US$1 billion any credit-granting errors due to noisy screening technology are eliminated. Although it is reasonable to assume that some lines of credit ``get through'' when they shouldnÕt, it is also reasonable to assume that US$1 billion lines of credit are given a much ®ner screening than others. 6 US$1 billion is ad hoc but there can be no denying that a US$1billion line of credit is large and it should suit the purposes of this paper. 7 A Citibank advertisement in the WSJ points this out. ``In 1893, CIGNA retained Citibank and never looked back.'' (WSJ, 18 January 1995, p. A9) In this case, CIGNA has stayed with Citibank for over 100 years. 8 Persistence is used in the sense of Kormendi and Lipe (1987).
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3. Methodology The market reaction is investigated by examining abnormal returns of the bankÕs stock on the date the line of credit becomes known to the market. Abnormal returns are typically isolated by using some derivation of the market model: Rit ai bi Rmt ei ;
1
where Rit is the return for security i at time period t, Rmt the equally weighted market return at time period t, ai the intercept parameter which varies with each security, bi the covariance of return of security i with the market return and ei is the error term normally distributed with mean of 0, independent of b1i , and uncorrelated across companies. Banking, more than most industries, is aected by changes in interest rates. Flannery and James (1984) and Blacconiere (1991), among others, develop a two variable market model and test several alternative interest rates. They ®nd that banks are ``very sensitive to interest rate changes regardless of the interest rate index employed''. In this study, the market model is modi®ed by adding the return of a readily identi®able interest rate, one year Treasury Bills: Rit ai b1i Rmt b2i Rtbt ei ;
2
where Rtbt is the return for one year Treasury Bills at time period t, b2i the sensitivity of stock i to the movement of interest rates and others as above. The statistic of interest in most event studies, cumulative abnormal returns (CAR), is the sum of the error terms during the event period. Two weaknesses with CARs for an event study are the use of only historical data in the estimation process and the assumption of a constant beta. To compensate for this, a ``dummy'' variable is added to Model (2) representing the event period. This technique is outlined in Binder (1985) and has been used in such works as Malatesta (1986); Schipper and Thompson (1985); Thompson (1985), and De Jong et al. (1992), but appears not to be widely used in the ®nance literature. This lack of use is despite the fact that the basic assumption in the development of CARs, that the error term and thus the returns follow a normal distribution with a constant variance, is shown by Connolly (1989) and con®rmed by De Jong et al. (1992) not to hold with actual data. By using a ``dummy'' variable and extending the regression past the event period, the model incorporates both pre- and post-event data. 9 Since it is not the purpose of this study to 9 If the regression is not extended past the event period, the use of CARÕs and the use of a dummy variable is mathematically equivalent. Kara®ath (1988) shows mathematically the equivalence between the traditional two-step procedure using CAR's and the use of dummy variables.
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predict but to identify an abnormal return, including information that occurred after the event of interest does not bias the results. On the other hand, including both pre- and post-event information controls for the eects of a stochastic beta. Model (2) is therefore modi®ed to include a dummy variable that is one during the event window and zero otherwise: Rit ai b1i Rmt b2i Rtbt b3i Di ei :
3
The coecient of interest in this study is the coecient on the dummy variable. If that coecient is signi®cant, it indicates a market reaction to the announcement. To insure that the borrowers in this study react to the announcement that they are granted a line of credit in the same manner as in prior studies, similar tests are performed. In addition to verifying prior works, the results are important to this paper because the reaction of the borrower is used to identify the exact date the market becomes aware a line of credit is granted. Both borrowers and banks have the same event date since they are both aected by the same event. The ability to identify the exact date the market becomes aware a line of credit is granted allows the event window to be one day, thereby increasing the power of the tests over those using longer event windows by eliminating the noise of non-event days. This study is done in event time as opposed to real time, therefore, the problem of correlation between the error terms is mitigated to the point where it is no longer a consideration. The use of event time, in addition to a very short window, also tends to remove the confounding eects of clustering.
4. Data To be included in the sample, the bank and the borrower must have daily data in the 1996 Center for Research in Security Prices (CRSP) tapes. There are two types of sources available to locate announcement dates for lines of credit; business newspapers, such as the WSJ, and commercial services. Prior studies use announcements in the WSJ to identify when a line of credit is granted. An announcement can only be formally released for publication by the borrower or by the bank with permission of the borrower. This leads to a possible selection bias in that only the highest quality borrowers allow the information to be announced. Therefore, using the borrowerÕs announcements may have led to bias in prior studies. Since the sample would thus be biased toward the alternative, the results are suspect. The other sources used for announcement dates are commercial services such as the Loan Pricing Corporation. Information about banks issuing lines of credit is published on a weekly basis by the Loan Pricing
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Corporation. This weekly report, the Gold Sheets, is the source for the data published in the American Banker, the newspaper of the American Bankers Association. There are actually three announcement dates available in the Gold Sheets. The ®rst is an announcement that should be considered a highly reliable rumor and is listed in a section called ``Late Breaking News''. Information is obtained from contacts the reporters at the Gold Sheets have established with dierent banks. This announcement does not contain complete information about the line of credit and is not a formal release. It usually reports the borrowerÕs name, line of credit notional amount and the lead bank or banks involved. This date, for purposes of this study, is referred to as Event 1. The second date of interest is more formal and complete. It is reported in the Gold Sheets after all information becomes available either through SEC ®lings or other ocial sources. This announcement reports in abbreviated form the full details of the line of credit including the amount, terms and actual grant date. This second date is referred to as Event 2 and the actual grant date is referred to as Event 3. For each event, all banks mentioned in the Gold Sheets are included in the sample. For Event 1 this is usually the lead bank or banks while for Events 2 and 3 major participating banks are also included. As a result, the number of banks is limited by the data available in the Gold Sheets. The ®rst step in the process is to isolate the exact date the borrower reacts to the announcement. This date is then used as the event date for the bank. To do this similar tests to those used in prior studies to determine whether the borrowerÕs stock reacts are performed. The current tests dier from those in prior studies in two ways. First, the methodology in this paper is dierent from prior works. Second, as discussed above, Event 1, the ``highly reliable rumor'' is totally dierent from the WSJ announcements used in prior studies and was not available when the prior works were done. The WSJ announcements used in prior works, along with Event 2 and Event 3 from this paper, are not rumors by the time they are released but facts that have been formally reported to a regulating agency. The initial window used to investigate the borrowerÕs reaction to the event is ®ve days. The length of the window is to include all business days between publications of the Gold Sheets. The Gold Sheets are dated on Monday but actually ``go to press'' at the close of business the previous Thursday. The ®ve day window encompasses all business days prior to the current publicationÕs cut-o back to the previous publicationÕs cut-o (i.e. start of business on Friday to close of business on Thursday). Any information contained in the Gold Sheets must be known as of the close of business Thursday. It can be assumed that, in addition to the reporters from the Loan Pricing Corporation, bank analysts and other professional investors also call their sources inside banks and are given this information. Therefore, if the Loan Pricing Corporation is
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aware of information about a bank or borrower, the market is also aware of this information. 10 One concern in compiling this sample, due to the size of both the banks and the borrowers, is confounding events. A search of the WSJ for any events from three business days before to three days after the event window was made and any observation with a confounding event was removed from the sample. In the search for confounding events it is interesting to note that none of the lines of credit are announced in the WSJ. If this study were conducted using the same techniques as prior studies, obtaining announcements from the WSJ, the largest lines of credit granted would not have been included in the samples. A potential explanation for the lack of announcements is that borrowers no longer feel it is necessary to announce a line of credit in the WSJ because they, and other interested parties, can rely on the Gold Sheets. Thus, it is the announcements in the Gold Sheets that drive the market rather than those from the WSJ. 5. Results Table 1 contains the results from the tests of borrowers granted lines of credit. These tests are conducted for each event period using the ®ve day window. It should be noted that, as expected, there are less observations in Event 1, ``Late Breaking News'', than in the other events. The reason for this is that not all lines of credit are known before the ocial release. It should also be noted that the variable representing the return of Treasury Bills is not included in this model. There is no reason to expect interest rates to aect companies, other than ®nancial institutions, in a signi®cant way. 11 Only one event is signi®cant, Event 1. The coecient on the variable of interest, the dummy variable, is both positive and signi®cant. Therefore, it appears that either prior data sets are unbiased, the bias had no eect on the results, or this data set contains a similar bias. Although both the methodology and the Event 1 announcements used in this study are dierent from those used in prior papers, the ®ndings are similar. A plausible explanation for the similar ®ndings is that the WSJ announcements used in prior studies are the ®rst indication of a line of credit whereas the ``Late Breaking News'' announcement, Event 1, is now the ®rst indication. If this is the case, the market no longer waits
10
Recently a new feature available to subscribers of the Gold Sheets is the option of having the information faxed to them when it becomes available to the Loan Pricing Corporation. Future work in the market microstructure area could be done using this data. 11 Tests were also conducted including the return on Treasury Bills and the results are the same, the interest rate variable is insigni®cant.
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Table 1 Event study by event for companies granted lines of credit ®ve day event windowa b2
R2
Event of interest
Obs
a
b1
Event 1
155
ÿ0.0007 (ÿ3.63)
1.13 (20.98)
0.004 (2.05)
0.05
Event 2
239
ÿ0.0006 (ÿ3.30)
1.12 (20.45)
0.0007 (0.51)
0.05
Event 3
239
ÿ0.0006 (ÿ3.47)
1.12 (20.43)
ÿ0.0005 (ÿ0.25)
0.05
a
Rit ai b1i Rmt b2i Di ei , where: Rit is the return for security i at time period t, Rmt the equally weighted market return at time period t, ai the intercept parameter which varies with each security, b1i the covariance of return of security i with the market return, b2i the sensitivity of stock i to the movement of interest rates, Di the dummy variable, 1 if within event window, 0 otherwise and ei is the error term normally distributed with mean of 0, independent of b1i , and b2i , and uncorrelated across companies. These tests of the borrowerÕs market reaction do not include the return on Treasury Bills as a variable. There is no reason to predict a change in interest rate would have an eect on a non-®nancial company. t-statistics are in parentheses. * Signi®cant at the 0.01 level. ** Signi®cant at the 0.05 level.
for a WSJ announcement and, although the announcements may be dierent in nature (Event 1 is a reliable rumor whereas the WSJ announcement is a established fact), they are the same in content in that they are both the ®rst indication to the market of a line of credit. This ®nding adds credence to the above stated suspicion that large borrowers no longer feel it necessary to announce their lines of credit in the WSJ. It should also be noted that the coecient and signi®cance level in this study is approximately equal to the ®ndings in BFG on more reputable lenders. Given the size of the lines of credit in this study, ®nding that the lead banks are perceived as more reputable is not surprising. To identify the exact date the market becomes aware a line of credit is granted, event studies are performed on individual borrowers for each of the ®ve days in the window for Event 1 to identify which of the ®ve days are signi®cant. 12 In order to obtain a ``clean'' sample any borrower with more than one signi®cant day is eliminated. All borrowers have at least one signi®cant day during the ®ve day window and only ®ve observations were lost due the borrower having more than one signi®cant day. 13 The results are a clean sample as far as confounding events related to the borrower. Each borrower has one speci®c date during the event window when there is a signi®cant 12
The same procedures were used for a sample from Event 2 and Event 3. None of the days had a signi®cant market reaction. 13 Tests of the borrowers on Event 1 were conducted with only the clean borrowers to ascertain if the results are being driven by the observations with more than one signi®cant date. The results do not change.
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reaction. Thus, the exact date the market becomes aware the line of credit is granted is identi®ed. This is the date used as the one day event window in testing the bankÕs stock reaction. There is no reason, other than granting the line of credit, that the bankÕs stock would have a signi®cant abnormal return on the exact date of the borrowerÕs reaction. The 150 remaining observations comprise the initial sample for testing bank stockÕs reaction. A breakdown by year of the observations is shown in Table 2(a). As can be seen, the total value of the lines of credit is signi®cant, Table 2 Lines of credit granted from 1993 to 1996 and used in the ®nal sample (a) Large lines of credit announced in ``Late Breaking News'' by yeara Year Banks Lines of credit 1993 1994 1995 1996
7 13 11 9
42 48 45 15
107.60 101.57 100.00 30.40
ALL
14
150
339.57
150 (57) (27)
339.57 (128.67) (54.50)
(b) Large lines of credit used in ®nal analysisb Beginning sample 14 Confounding events 0 Unavailable on (2) CRSP Final sample (c) Banks granting lines Year/Bank Bank of Boston Bank of New York Bank of America Bankers Trust Chase Manhattan Chemical Bank Citibank First Chicago Morgan Nationsbank Wachovia Wells Fargo a
Line of credit value (US$ billion)
12 of credit by yearc 1993 1994 1.2 3.7 5.4 8.3 5.0 7.3 5.1 16.5 29.9 8.8 14.6 5.5 6.5 24.2 3.2 1.9
66
156.40
1995 2.5 17.5 29.7 9.1 9.7 45.5 12.0 1.0 28.8 6.5
1996 5.4 4.3 2.9 2.8 12.4 8.6 1.8
The number of banks do not add up to the ``ALL'' because many of the same banks granted lines of credit in several years. b Reasons for eleminating banks or lines of credit from the ®nal sample. c The amounts of lines of credit granted by each bank does not add up to the total granted for each year. The reason for this is that in many cases more than one of the banks was involved with granting the line of credit.
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US$339.57 billion. It also illustrates that there are few banks (14) in both the ®nancial position and with the expertise to act as a lead or co-lead in establishing a US$1 billion line of credit syndication. Each yearÕs number of banks do not add up to the total because many of the same banks are involved each year. Therefore, prior to eliminating confounding events, the sample consists of 14 banks and 150 lines of credit over US$1 billion during the time period 1993± 1996. Confounding events, in this portion of the study, are de®ned as any news article about the bank within a seven day window around the event date. The results of a search for confounding events are found in Table 2(b). Fifty-seven lines of credit are lost due to confounding events. In addition to confounding events, two banks representing 27 lines of credit are eliminated because their returns are not found in CRSP, these are both foreign banks. The ®nal 12 banks remaining in the sample represent all banks mentioned in the ``Late Breaking News'' section of the Gold Sheets. As would be expected, only the largest banks become involved as the lead or one of the co-lead banks on a US$1 billion line of credit. Table 2(c) lists the banks involved and the amounts of their lines of credit by year. The amounts do not add up to the total lines of credit granted, Table 2(b), because several of the lines of credit involved multiple banks. By any de®nition all of these banks are considered more reputable. Tests are conducted on the sample using Model (3). As shown in Table 3, the coecient on the variable of interest, the dummy, is positive and signi®cant. This indicates that when a bank grants a line of credit of this magnitude to a large ®rm, not only is a strong signal sent to the market about the borrower but a signal is also sent about the bank. It is also an indication that the bankÕs reaction is a result of the signal. If the reaction were caused either by incorporation of a new permanent income stream or the recognition that lines of credit are positive net present value transactions, the coecient for the bank would be substantially smaller.
Table 3 Results of event study of banksa
a
Variable
a
Rmt
Rtb t
Di
R2
Coecient (t-statistics)
0.0002 (0.953)
0.8329 (20.231)
ÿ0.2945 (ÿ16.848)
0.0044 (1.969)
0.1405
Rit ai b1i Rmt b2i Rtbt b3i Di ei . The ®nal sample from Table 2 of 12 banks and 66 lines of credit is used in the event study below. Model (3) is used to test the market reaction of the bankÕs stock on the date that the market becomes aware a line of credit is granted. * Signi®cant at the 0.01 level. ** Signi®cant at the 0.05 level.
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6. Summary This study investigates lines of credit to ascertain whether the market considers them value relevant for banks and impounds this information into the bankÕs stock price. Prior studies have shown that the market considers lines of credit value relevant for the borrower. A positive and signi®cant market reaction of the borrowerÕs stock occurs when the market becomes aware a line of credit is granted. This is the ®rst study to test whether there is a market reaction of the bankÕs stock when the bank grants a line of credit. A unique data set is compiled for this study. Observations are drawn from the set of all lines of credit granted during the years 1993±1996. This data gathering technique eliminates potential bias found in prior studies. To insure that the borrowers in this study react to the announcement that they are granted a line of credit in the same manner as borrowers in prior studies, similar tests are performed and prior results con®rmed. In addition to verifying prior works, these results are used to identify the precise date the market becomes aware a line of credit is granted. The ability to identify this date allows the event window to be one day. This increases the power of the tests over those using longer event windows by removing the noise of the non-event days. The current view of lines of credit is that they are a put option and, given the competitive nature of the banking industry, zero net present value projects. Therefore, no reaction is expected when the market becomes aware the bank has granted a large line of credit. This paper suggests two signaling hypotheses consistent with the bankÕs stock reacting positively. The announcement of a line of credit being granted by a bank can potentially produce two signals sent either individually or together. First, a signal is sent from the borrower that they are using the bank because they consider it strong and reliable. Second, a primary signal about the bankÕs future ®nancial position is indicated in several ways, all of which lead to a positive reaction. They include: a positive departure from competitive equilibrium in the area of lines of credit, potential increased future lending activity due to the bankÕs ability to maintain its competitiveness and in¯uential position in the allocation of credit, and it signals the bankÕs con®dence in their ability to fund any future obligations resulting from the exercise of lines of credit. The ®ndings show a positive and signi®cant market reaction of the bankÕs stock. These results suggests that a signal is sent to the market revealing the true nature of the bankÕs current and potential characteristics rather than impounding a speci®c transaction when a bank grants a large line of credit. The unique methodology used to identify the exact event date lends itself well to any other study where the event date of two entities are the same. Future research can take advantage of the new data source provided by the Loan Pricing Corporation to identify the actual time of day that the
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announcement becomes known by the market. This opens several avenues of research both for banks and borrowers.
Acknowledgements This paper represents a portion of my dissertation at the University of Oklahoma. I would like to thank my dissertation committee, Fran Ayres (Chair), Vic Bernard, Elizabeth Cunningham, Louis Ederington, Bart Ward and Lee Willinger for their many helpful suggestions and comments. This paper also bene®tted from the comments of participants at the 1997 Western American Accounting Association conference and two anonymous referees. I would also like to thank Crestar Bank, especially Sue Miller and Dawn Provost, for providing data used in this paper.
References Beatty, R.P., 1989. Auditor reputation and the pricing of initial public oerings. The Accounting Review 64, 693±709. Bernanke, B., 1983. Non-monetary eects of the ®nancial crisis in the propagation of the great depression. American Economic Review 73, 257±276. Best, R., Zhang, H., 1993. Alternative information sources and the information content of bank loans. Journal of Finance 4, 1507±1523. Billett, M.T., Flannery, M.J., Gar®nkel, J.A., 1995. The eect of lender identity on a borrowing ®rmÕs equity return. Journal of Finance, 699±718. Binder, J., 1985. Measuring the eects of regulation with stock price data. Rand Journal of Economics 16, 167±183. Blacconiere, W.G., 1991. Market reactions to accounting regulations in the savings and loan industry. Journal of Accounting and Economics 14, 91±113. Carter, R., Manaster, S., 1990. Initial public oerings and underwriter reputation. Journal of Finance 45, 1045±1067. Chemmanur, T.J., Fulghieri, P., 1994. Reputation, renegotiation, and the choice between bank loans and publicly traded debt. Review of Financial Studies 7, 475±506. Connolly, R.A., 1989. An examination of the robustness of the weekend eect. Journal of Financial and Quantitative Analysis 24, 133±169. De Jong, F., Kemna, A., Kloek, T., 1992. A contribution to event study methodology with an application to the dutch stock market. Journal of Banking and Finance 16, 11±36. Diamond, D.W., 1991. Monitoring and reputation: The choice between bank loans and directly placed debt. Journal of Political Economy 99, 689±721. Fama, E.F., 1985. WhatÕs dierent about banks? Journal of Monetary Economics, pp. 29±39. Flannery, M., James, C., 1984. The eect of interest rate changes on the common stock returns of ®nancial institutions. Journal of Finance 39, 1141±1153. Hull, R.M., Moellenberndt, R., 1994. Bank debt reduction announcements and negative signaling. Financial Management. 23 (2), 21±30. James, C., 1987. Some evidence on the uniqueness of bank loans. Journal of Financial Economics (December).
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Kane, E., Malkiel, B., 1965. Bank portfolio allocation, deposit variability and the availability doctrine. Quarterly Journal of Economics 79, 189±206. Kara®ath, I., 1988. Using dummy variables in the event methodology. The Financial Review 23 (3), 351±357. Kormendi, R.C., Lipe, R., 1987. Earnings innovations, earnings persistence, and stock returns. Journal of Business 60 (3), 323±345. Lummer, S., McConnell, J., 1989. Further evidence on the bank lending process and the capitalmarket response to bank loan agreements. Journal of Financial Economics 25. Malatesta, P., 1986. Measuring abnormal performance: The event parameter approach using joint generalized least squares. Journal of Financial and Quantitative Analysis 21, 27±38. Megginson, W., Poulsen, A., Sinkey Jr., 1995. Syndicated loan announcements and the market value of the banking ®rm. Journal of Money, Credit, and Banking 27 (2) 457±475. Merton, R.C., 1992. Operation and regulation of ®nancial intermediation: A functional perspective. Working Paper, Harvard University, Cambridge, MA. Mikkelson, W., Partch, M., 1986. Valuation eects of securities oerings and the issuance process. Journal of Financial Economics 15, 31±60. Preece, D.C., Mullineaux, D.J., 1994. Monitoring by ®nancial intermediaries: Banks vs. non banks. Journal of Financial Services Research 4, 191±200. Schipper, K., Thompson, R., 1985. The impact of merger-related regulations using exact distributions of test statistics. Journal of Accounting Research 23 (1), 408±415. Shockley, R.L., 1995. Bank loan commitments and corporate leverage. Journal of Financial Intermediation 4, 272±301. Slovin, M.B., Johnson, S.A., Glascock, J.L., 1992. Firm size and the information content of bank loan announcements. Journal of Banking and Finance 16, 1057±1071. Slovin, M.B., Sushka, M.E., Polonchek, J.A., 1993. The value of bank durability: Borrowers as bank stakeholders. Journal of Finance 48, 247±266. Stigum, M., 1990. The Money Market, Irwin, Homewood, IL. Thakor, A., Hong, H., Greenbaum, S.I., 1981. Bank loan commitments and interest rate volatility. Journal of Banking and Finance 5, 497±510. Thompson, R., 1985. Conditioning the return generating process on ®rm speci®c events: A discuss of event study methods. Journal of Financial and Quantitative Analysis 20, 151±186.
Market response to banks granting lines of credit Michael Mosebach
*
Department of Accounting, College of Business and Public Administration, Old Dominion University, Norfolk, VA 23529-0229, USA Received 29 April 1998; accepted 10 February 1999
Abstract Prior research has shown, and this paper con®rms, that when the market becomes aware a line of credit is granted, the borrowerÕs stock has a positive and signi®cant reaction. The borrowerÕs reaction is used to identify the exact date the market becomes aware of the granting of the line of credit. This date is used as a one day window to investigate whether the bankÕs stock also reacts. This reaction will be most obvious with large lines of credit. All lines of credit, larger than US$1 billion, granted during the years 1993±1996 are investigated. The results show, as predicted, a positive and signi®cant reaction by the bankÕs stock. Ó 1999 Elsevier Science B.V. All rights reserved. JEL classi®cation: G21 Keywords: Commercial banking; Lines of credit; Market reaction
1. Introduction This paper investigates the reaction of bank stocks to the announcement that the bank has granted a large line of credit. Existent research shows that the
*
Tel.: +1-757-683-4460; fax: +1-757-683-5639. E-mail address: [email protected] (M. Mosebach)
0378-4266/99/$ - see front matter Ó 1999 Elsevier Science B.V. All rights reserved. PII: S 0 3 7 8 - 4 2 6 6 ( 9 9 ) 0 0 0 2 1 - 7
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announcement generates a positive return for the borrowerÕs stock. This study empirically tests whether the bankÕs stock also reacts. Fama (1985) describes lines of credit as an excellent signaling device that are sometimes used by large companies for no other reason than to signal the market of the companyÕs ®nancial strength. Prior research con®rmed in this study, such as Mikkelson and Partch (1986), ®nds a signi®cant and positive reaction of the borrowerÕs stock to the announcement that a line of credit is granted. James (1987) shows that borrowers experience higher average abnormal returns when banks grant loans than when loans are granted by other lenders. Theoretical work, such as Chemmanur and Fulghieri (1994), empirically con®rmed by Billett et al. (1995) (BFG) indicate that ``more reputable'' lenders provide more new information to the market than ``less reputable'' lenders. BFG also propose that ®rms, in order to send the strongest signal possible, use the best lender available to them. These ®ndings suggest that lines of credit from banks, rather than other lenders, provide the best method of signaling the market. This signal is enhanced as the size of the line of credit increases. It therefore follows that large companies, in order to send the strongest possible signal to the market, use the best bank and largest line of credit available. The current understanding of lines of credit, and other types of loan commitments, is that they are put options. The bank sells the option and, given the competition in the banking industry, collects a fee equal to the present value of the option, therefore, no market reaction is expected. This study agrees that lines of credit are zero net present value transactions for the bank but suggests two related hypotheses consistent with positive market reactions. First, by using the bank, the borrower is signaling the market that they consider it the best lender available to them. Second, new positive information about the bankÕs current and future ®nancial position is transmitted to the market. Data are taken from a unique source consisting of the set of all lines of credit granted by banks during the years 1993±1996 regardless of whether there is a public announcement. This data source eliminates potential selection bias found in past data sets thus adding power to the tests. A more powerful method than used in prior work is also used to identify the event date. The reaction of the borrowerÕs stock is used to identify the exact date the market becomes aware a line of credit is granted. This date is used as a one day event window for the banks further increasing the power of the market reaction tests. The results show a positive and signi®cant market reaction by the bankÕs stock when the bank grants a large line of credit. Therefore, in addition to the signal sent to the market by the bank, a signal is sent to the market about the bank. These ®ndings provide further evidence of the importance of lines of credit as a signaling device. This paper also expands the literature on shareholder wealth eects from internal policy choices made by ®nancial institutions.
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2. Banks and lines of credit A line of credit is a commitment by a bank to loan money at some time in the future. The notional amount is the maximum that can be borrowed under the line of credit. The actual amount and timing of the borrowing is controlled by the borrowers who can draw on the line of credit as often as they like and for any amount as long as the total borrowed does not exceed the notional amount. Lines of credit are an important economic factor in the banking industry. On an average they represent 434% of the bank equity from 1987 to 1992. Lines of credit are also important in a larger economic sense. On 31 March 1998, banks insured by the Federal Deposit Insurance Corporation reported that US corporations held more than US$1280 billion in unused loan commitments and lines of credit. These commitments exceeded the US$820 billion of actual commercial and industrial loans made by US banks. Approximately 80% of commercial and industrial loans made by banks are made under loan commitments and lines of credit are a large portion of loan commitments. When a bank grants a line of credit, it is contractually obligated to lend funds upon demand. Entering into a contract of this nature is a signi®cant economic event for both the bank granting the line of credit and the company being granted the line of credit. Companies use lines of credit for three general reasons. The largest number of lines of credit are issued for operational reasons. Second, lines of credit are used as a good faith gesture to show ability to pay for some speci®c transaction. For instance, the stated purpose of many of the lines of credit investigated for this study is to acquire another company. The line of credit assures the target company that the acquiring company is capable of completing the transaction. This makes the company to be acquired more comfortable disclosing proprietary corporate information. Additionally, Stigum (1990, p. 1033) describes lines of credit as ``insurance premiums'' for commercial paper issuers. Due to the short-term nature of most commercial papers, there is always a risk that the issuer will be unable to roll them over. Therefore, ``...all issuers back their outstanding paper with bank lines of credit... (primarily because)...investors will buy only paper backed by bank lines.'' The above uses of lines of credit have underlying operational purposes. The ®nal reason companies obtain lines of credit is to signal the market. These signals are used to reduce information asymmetries between company management and the market about the companyÕs ®nancial condition. Kane and Malkiel (1965), Bernanke (1983), Fama (1985), and James (1987) all indicate that banks, having virtually unlimited access to corporate information, including past deposit information, are in the unique position of having little or no information asymmetries. Therefore, bankÕs information is perceived as insider information by the market. Thus, when a bank grants a line of credit,
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the market interprets this as a signal from the bank that the company is ®nancially strong, thereby reducing the information asymmetries. Shockley (1995) demonstrates another ®nding signaled to the market. He shows that organizations with unused loan commitments have access to less costly debt. As a result, the borrower, having access to lower cost debt, is in the position of generating higher returns on projects. One indication of the value of this signal is found in Fama (1985): ``...many organizations pay periodic monitoring fees for lines of credit from banks even though they do not take the resources oered. Indeed, large corporations often purchase lines of credit from banks for the sole purpose of providing a signal...'' It should be noted that even when the line of credit is for operating purposes, a signal is still sent to the market. Mikkelson and Partch (1986); James (1987); Lummer and McConnell (1989); Slovin et al. (1992); Best and Zhang (1993), and Preece and Mullineaux (1994) empirically demonstrate the value of this signal by showing that the market reaction of the borrowerÕs stock to the announcement that a line of credit is granted is positive and signi®cant. Additionally, James (1987) ®nds that bank loans provide a larger abnormal return to the borrower than loans made by other institutions. 1 Lummer and McConnell (1989) and Best and Zhang (1993) ®nd a signi®cant dierence between new bank loans and renewals. New loans are made utilizing only information that is already available to the market whereas renewals are made using proprietary information that is acquired from an ongoing relationship. Therefore, a stronger signal is sent at renewal due to the perceived revelation of insider information. This reasoning is supported by the empirical ®ndings of Slovin et al. (1993) who show that replacing an existing banking relationship is costly. In eect, an existing relationship allows a higher quality of monitoring by the lender due to their special knowledge of the borrower. Fama (1985) and Diamond (1991) posit that larger, highly visible borrowers will not bene®t as much from this signal. There are less perceived bene®ts from bank monitoring, because large borrowers are more likely to be monitored by other sources such as analysts, bond rating agencies and the ®nancial press, than smaller and less visible borrowers. This is con®rmed by Slovin et al. (1992) who show that larger borrowers receive smaller abnormal returns than smaller borrowers.
1 Preece and Mullineaux (1994) in a study of short-term loans ®nd no dierence between the various types of lending institutions. Although this contrasts with JamesÕ results, their sample is limited to short-term borrowings, therefore, the results may be unique to that sample or type of loan thus explaining the dierence.
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Chemmanur and Fulghieri (1994) develop a theoretical model that suggests more reputable banks are able to convey more information than less reputable banks. BFG empirically test this proposition and ``...®nd strong evidence that higher quality lenders are associated with signi®cantly higher abnormal returns to borrowerÕs stock, even after controlling for borrower characteristics''. This makes a strong case for the speci®c identity of the lender being an important factor. Work in other areas, Beatty (1989) in auditing and Carter and Manaster (1990) for underwriters, for instance, show that there are reputation eects. The ®ndings in BFG bring the reputation eect into banking. It appears the higher the perceived quality of the agent, be it auditor, underwriter or bank, the more credence the market gives to the information. Therefore, high quality banks are able to signal more reliable information to the market. Large borrowers tend to use banks that are perceived as more reputable. This may explain why there is a signi®cant market reaction by large borrowers that are already tightly monitored by sources other than banks. A strong borrower uses the best signaling device available. Very large companies that use large lines of credit as a signal, therefore, use the most reputable banks available. Merton (1992) indicates that since it is costly to establish or replace a banking relationship, a bankÕs ability to sell its services is enhanced if the market perceives them as being a higher quality bank. It follows that this perception is reinforced if the bank has a large number of strong, high prestige corporate clients. Accordingly, banks will tend to cultivate clients that add to their reputation. Therefore, large strong companies can utilize almost any bank they desire. In addition to the unidirectional eects of the signal, this paper posits that feedback from the borrower about the bank exists. By using the bank, a strong company indicates that it considers the bank an excellent signaling device due to its ®nancial strength and reputation. To eliminate the concern that the lender, in addition to being the best available, may be the only lender available, only large borrowers seeking very large lines of credit are investigated. These large borrowers can use any bank. The market interprets the use of the bank by a strong, high prestige borrower as an indication of the bankÕs strength. There are anecdotal indications that bankers consider it a positive signal when a large borrower uses their bank to obtain a line of credit. Advertisements by First Union Bank found in both Business Week and The Wall Street Journal (WSJ) show prestigious borrowers that have been granted large lines of credit by First Union Bank. For instance, Penske Truck Leasing was granted an US$800,000,000 line of credit by First Union Bank. This was used in First UnionÕs full page advertisement in the WSJ and two page ad in Business Week. In addition to the signal discussed above about the bank from the borrower, this paper also posits that granting a line of credit sends a primary signal to the market about the ®nancial condition of the bank. Assuming lines of credit,
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acting as puts, are correctly priced and competition drives average returns to normal, the market will only react when a line of credit is issued if new information is conveyed. A change in the marketÕs expectations of future cash ¯ows is a necessary condition for an identi®able market reaction to any event. 2 Granting lines of credit is an ongoing function of banks. The market anticipates this much as it would normal sales for any other business. These expectations of the bankÕs performance are impounded into the price of the bankÕs stock. Each announcement is seen as an anticipated sale, therefore, not changing expectations. Alternatively, there is no a priori reason to believe the market is able to anticipate a new and very large line of credit. Thus, very large lines of credit are capable of changing the marketÕs expectation and providing new information. There are several equally plausible ways the market can interpret this signal that will positively change the marketÕs expectations. Granting large lines of credit may signal the market that line of credit activity is higher than expected and the bank is experiencing a short-term positive departure from competitive equilibrium. 3 Any departure from competitive equilibrium leads to a reevaluation of the companyÕs stock by the market. A positive departure such as this leads to an increase in the price of the stock. Megginson et al. (1995) suggest that a bankÕs ability to arrange large loans signals the market that the bank is maintaining its competitiveness. Shockley (1995) describes a related signal sent to the market. He maintains ``...that banks can play an important role in the allocation of credit whether or not they actually fund loans. This is germane given the current debate regarding the relevance of banks, vis-a-vis the capital markets, in the allocation of credit''. A bankÕs ability to arrange large lines of credit, especially for a large, high prestige client, shows the market that not only is the bank maintaining its competitiveness but it is currently, and will be in the future, a signi®cant participant in the allocation of credit. Additionally, it signals the market that the bank is con®dent in its ability to honor any future ®nancial obligation stemming from the exercise of the line of credit. 4 All of these signals lead to positive abnormal returns for bank stocks.
2 Although necessary, it is not a sucient condition because there could be an equal and osetting change in the risk factor which would cause the stock price to remain unchanged, thus there would be no market reaction. 3 The opposite is true for smaller than anticipated activity in lines of credit. ``Smaller than anticipated'' is dicult to quantify and is beyond the scope of this study. 4 One empirical implication is that the signal is more informative to the market for less reputable banks, in that there is more of a surprise, than it is for more reputable banks, leading to a greater market reaction for less reputable banks. In order to test this, a strati®ed sample of banks is required. Due to the homogeneous makeup of the sample in this paper, testing this empirical implication is not possible. Thanks go to an anonymous reviewer for this suggestion.
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Large lines of credit are usually underwritten by more than one bank. One or more banks act as lead or co-lead banks and form a syndication with other participating banks to fund the line. In this study US$1 billion is used as the cut-o for lines of credit. 5 Every line of credit in the sample is syndicated, and considering their size, this is not a surprise. Given that each bank is only committed to a percentage of the large line of credit, lines of credit smaller than US$1 billion may not be large enough to aect signi®cant economic re-evaluation of the bankÕs stock. 6 In most instances, the lead bank or banks have an ongoing relationship with the borrower. Therefore, even though the line of credit itself may be a new transaction, a strong signal is sent to the market due to the existing relationship. It has been shown empirically Lummer and McConnell (1989) and Hull and Moellenberndt (1994) when a line of credit is terminated, a negative signal about the borrower is sent to the market. As a result, borrowers have a strong incentive not to discontinue their lines of credit. Additionally, if the borrower uses the line of credit strictly as a signaling device they cannot discontinue the line of credit without defeating the purpose. An indication of the marketÕs expectation that a line of credit is a perpetuity for the bank is that the maturity is rarely mentioned at the announcement that a line of credit is granted and renewal announcements are rare. Prior research, such as Thakor et al. (1981), also shows that companies are reluctant to change banks. Very large companies change banks so rarely that the probability of them changing banks is essentially zero. 7 If the company is not going to change banks or discontinue its line of credit, the revenue stream from the line of credit should be perceived as persistent. 8 Therefore, large lines of credit, in addition to signaling a positive departure from competitive equilibrium, represent a new and permanent income stream to the bank and can indicate future increases in line of credit and loan activity due to the bank maintaining both its overall competitiveness and its position in the allocation of credit.
5 By limiting the lines of credit to those over US$1 billion any credit-granting errors due to noisy screening technology are eliminated. Although it is reasonable to assume that some lines of credit ``get through'' when they shouldnÕt, it is also reasonable to assume that US$1 billion lines of credit are given a much ®ner screening than others. 6 US$1 billion is ad hoc but there can be no denying that a US$1billion line of credit is large and it should suit the purposes of this paper. 7 A Citibank advertisement in the WSJ points this out. ``In 1893, CIGNA retained Citibank and never looked back.'' (WSJ, 18 January 1995, p. A9) In this case, CIGNA has stayed with Citibank for over 100 years. 8 Persistence is used in the sense of Kormendi and Lipe (1987).
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3. Methodology The market reaction is investigated by examining abnormal returns of the bankÕs stock on the date the line of credit becomes known to the market. Abnormal returns are typically isolated by using some derivation of the market model: Rit ai bi Rmt ei ;
1
where Rit is the return for security i at time period t, Rmt the equally weighted market return at time period t, ai the intercept parameter which varies with each security, bi the covariance of return of security i with the market return and ei is the error term normally distributed with mean of 0, independent of b1i , and uncorrelated across companies. Banking, more than most industries, is aected by changes in interest rates. Flannery and James (1984) and Blacconiere (1991), among others, develop a two variable market model and test several alternative interest rates. They ®nd that banks are ``very sensitive to interest rate changes regardless of the interest rate index employed''. In this study, the market model is modi®ed by adding the return of a readily identi®able interest rate, one year Treasury Bills: Rit ai b1i Rmt b2i Rtbt ei ;
2
where Rtbt is the return for one year Treasury Bills at time period t, b2i the sensitivity of stock i to the movement of interest rates and others as above. The statistic of interest in most event studies, cumulative abnormal returns (CAR), is the sum of the error terms during the event period. Two weaknesses with CARs for an event study are the use of only historical data in the estimation process and the assumption of a constant beta. To compensate for this, a ``dummy'' variable is added to Model (2) representing the event period. This technique is outlined in Binder (1985) and has been used in such works as Malatesta (1986); Schipper and Thompson (1985); Thompson (1985), and De Jong et al. (1992), but appears not to be widely used in the ®nance literature. This lack of use is despite the fact that the basic assumption in the development of CARs, that the error term and thus the returns follow a normal distribution with a constant variance, is shown by Connolly (1989) and con®rmed by De Jong et al. (1992) not to hold with actual data. By using a ``dummy'' variable and extending the regression past the event period, the model incorporates both pre- and post-event data. 9 Since it is not the purpose of this study to 9 If the regression is not extended past the event period, the use of CARÕs and the use of a dummy variable is mathematically equivalent. Kara®ath (1988) shows mathematically the equivalence between the traditional two-step procedure using CAR's and the use of dummy variables.
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predict but to identify an abnormal return, including information that occurred after the event of interest does not bias the results. On the other hand, including both pre- and post-event information controls for the eects of a stochastic beta. Model (2) is therefore modi®ed to include a dummy variable that is one during the event window and zero otherwise: Rit ai b1i Rmt b2i Rtbt b3i Di ei :
3
The coecient of interest in this study is the coecient on the dummy variable. If that coecient is signi®cant, it indicates a market reaction to the announcement. To insure that the borrowers in this study react to the announcement that they are granted a line of credit in the same manner as in prior studies, similar tests are performed. In addition to verifying prior works, the results are important to this paper because the reaction of the borrower is used to identify the exact date the market becomes aware a line of credit is granted. Both borrowers and banks have the same event date since they are both aected by the same event. The ability to identify the exact date the market becomes aware a line of credit is granted allows the event window to be one day, thereby increasing the power of the tests over those using longer event windows by eliminating the noise of non-event days. This study is done in event time as opposed to real time, therefore, the problem of correlation between the error terms is mitigated to the point where it is no longer a consideration. The use of event time, in addition to a very short window, also tends to remove the confounding eects of clustering.
4. Data To be included in the sample, the bank and the borrower must have daily data in the 1996 Center for Research in Security Prices (CRSP) tapes. There are two types of sources available to locate announcement dates for lines of credit; business newspapers, such as the WSJ, and commercial services. Prior studies use announcements in the WSJ to identify when a line of credit is granted. An announcement can only be formally released for publication by the borrower or by the bank with permission of the borrower. This leads to a possible selection bias in that only the highest quality borrowers allow the information to be announced. Therefore, using the borrowerÕs announcements may have led to bias in prior studies. Since the sample would thus be biased toward the alternative, the results are suspect. The other sources used for announcement dates are commercial services such as the Loan Pricing Corporation. Information about banks issuing lines of credit is published on a weekly basis by the Loan Pricing
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Corporation. This weekly report, the Gold Sheets, is the source for the data published in the American Banker, the newspaper of the American Bankers Association. There are actually three announcement dates available in the Gold Sheets. The ®rst is an announcement that should be considered a highly reliable rumor and is listed in a section called ``Late Breaking News''. Information is obtained from contacts the reporters at the Gold Sheets have established with dierent banks. This announcement does not contain complete information about the line of credit and is not a formal release. It usually reports the borrowerÕs name, line of credit notional amount and the lead bank or banks involved. This date, for purposes of this study, is referred to as Event 1. The second date of interest is more formal and complete. It is reported in the Gold Sheets after all information becomes available either through SEC ®lings or other ocial sources. This announcement reports in abbreviated form the full details of the line of credit including the amount, terms and actual grant date. This second date is referred to as Event 2 and the actual grant date is referred to as Event 3. For each event, all banks mentioned in the Gold Sheets are included in the sample. For Event 1 this is usually the lead bank or banks while for Events 2 and 3 major participating banks are also included. As a result, the number of banks is limited by the data available in the Gold Sheets. The ®rst step in the process is to isolate the exact date the borrower reacts to the announcement. This date is then used as the event date for the bank. To do this similar tests to those used in prior studies to determine whether the borrowerÕs stock reacts are performed. The current tests dier from those in prior studies in two ways. First, the methodology in this paper is dierent from prior works. Second, as discussed above, Event 1, the ``highly reliable rumor'' is totally dierent from the WSJ announcements used in prior studies and was not available when the prior works were done. The WSJ announcements used in prior works, along with Event 2 and Event 3 from this paper, are not rumors by the time they are released but facts that have been formally reported to a regulating agency. The initial window used to investigate the borrowerÕs reaction to the event is ®ve days. The length of the window is to include all business days between publications of the Gold Sheets. The Gold Sheets are dated on Monday but actually ``go to press'' at the close of business the previous Thursday. The ®ve day window encompasses all business days prior to the current publicationÕs cut-o back to the previous publicationÕs cut-o (i.e. start of business on Friday to close of business on Thursday). Any information contained in the Gold Sheets must be known as of the close of business Thursday. It can be assumed that, in addition to the reporters from the Loan Pricing Corporation, bank analysts and other professional investors also call their sources inside banks and are given this information. Therefore, if the Loan Pricing Corporation is
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aware of information about a bank or borrower, the market is also aware of this information. 10 One concern in compiling this sample, due to the size of both the banks and the borrowers, is confounding events. A search of the WSJ for any events from three business days before to three days after the event window was made and any observation with a confounding event was removed from the sample. In the search for confounding events it is interesting to note that none of the lines of credit are announced in the WSJ. If this study were conducted using the same techniques as prior studies, obtaining announcements from the WSJ, the largest lines of credit granted would not have been included in the samples. A potential explanation for the lack of announcements is that borrowers no longer feel it is necessary to announce a line of credit in the WSJ because they, and other interested parties, can rely on the Gold Sheets. Thus, it is the announcements in the Gold Sheets that drive the market rather than those from the WSJ. 5. Results Table 1 contains the results from the tests of borrowers granted lines of credit. These tests are conducted for each event period using the ®ve day window. It should be noted that, as expected, there are less observations in Event 1, ``Late Breaking News'', than in the other events. The reason for this is that not all lines of credit are known before the ocial release. It should also be noted that the variable representing the return of Treasury Bills is not included in this model. There is no reason to expect interest rates to aect companies, other than ®nancial institutions, in a signi®cant way. 11 Only one event is signi®cant, Event 1. The coecient on the variable of interest, the dummy variable, is both positive and signi®cant. Therefore, it appears that either prior data sets are unbiased, the bias had no eect on the results, or this data set contains a similar bias. Although both the methodology and the Event 1 announcements used in this study are dierent from those used in prior papers, the ®ndings are similar. A plausible explanation for the similar ®ndings is that the WSJ announcements used in prior studies are the ®rst indication of a line of credit whereas the ``Late Breaking News'' announcement, Event 1, is now the ®rst indication. If this is the case, the market no longer waits
10
Recently a new feature available to subscribers of the Gold Sheets is the option of having the information faxed to them when it becomes available to the Loan Pricing Corporation. Future work in the market microstructure area could be done using this data. 11 Tests were also conducted including the return on Treasury Bills and the results are the same, the interest rate variable is insigni®cant.
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Table 1 Event study by event for companies granted lines of credit ®ve day event windowa b2
R2
Event of interest
Obs
a
b1
Event 1
155
ÿ0.0007 (ÿ3.63)
1.13 (20.98)
0.004 (2.05)
0.05
Event 2
239
ÿ0.0006 (ÿ3.30)
1.12 (20.45)
0.0007 (0.51)
0.05
Event 3
239
ÿ0.0006 (ÿ3.47)
1.12 (20.43)
ÿ0.0005 (ÿ0.25)
0.05
a
Rit ai b1i Rmt b2i Di ei , where: Rit is the return for security i at time period t, Rmt the equally weighted market return at time period t, ai the intercept parameter which varies with each security, b1i the covariance of return of security i with the market return, b2i the sensitivity of stock i to the movement of interest rates, Di the dummy variable, 1 if within event window, 0 otherwise and ei is the error term normally distributed with mean of 0, independent of b1i , and b2i , and uncorrelated across companies. These tests of the borrowerÕs market reaction do not include the return on Treasury Bills as a variable. There is no reason to predict a change in interest rate would have an eect on a non-®nancial company. t-statistics are in parentheses. * Signi®cant at the 0.01 level. ** Signi®cant at the 0.05 level.
for a WSJ announcement and, although the announcements may be dierent in nature (Event 1 is a reliable rumor whereas the WSJ announcement is a established fact), they are the same in content in that they are both the ®rst indication to the market of a line of credit. This ®nding adds credence to the above stated suspicion that large borrowers no longer feel it necessary to announce their lines of credit in the WSJ. It should also be noted that the coecient and signi®cance level in this study is approximately equal to the ®ndings in BFG on more reputable lenders. Given the size of the lines of credit in this study, ®nding that the lead banks are perceived as more reputable is not surprising. To identify the exact date the market becomes aware a line of credit is granted, event studies are performed on individual borrowers for each of the ®ve days in the window for Event 1 to identify which of the ®ve days are signi®cant. 12 In order to obtain a ``clean'' sample any borrower with more than one signi®cant day is eliminated. All borrowers have at least one signi®cant day during the ®ve day window and only ®ve observations were lost due the borrower having more than one signi®cant day. 13 The results are a clean sample as far as confounding events related to the borrower. Each borrower has one speci®c date during the event window when there is a signi®cant 12
The same procedures were used for a sample from Event 2 and Event 3. None of the days had a signi®cant market reaction. 13 Tests of the borrowers on Event 1 were conducted with only the clean borrowers to ascertain if the results are being driven by the observations with more than one signi®cant date. The results do not change.
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reaction. Thus, the exact date the market becomes aware the line of credit is granted is identi®ed. This is the date used as the one day event window in testing the bankÕs stock reaction. There is no reason, other than granting the line of credit, that the bankÕs stock would have a signi®cant abnormal return on the exact date of the borrowerÕs reaction. The 150 remaining observations comprise the initial sample for testing bank stockÕs reaction. A breakdown by year of the observations is shown in Table 2(a). As can be seen, the total value of the lines of credit is signi®cant, Table 2 Lines of credit granted from 1993 to 1996 and used in the ®nal sample (a) Large lines of credit announced in ``Late Breaking News'' by yeara Year Banks Lines of credit 1993 1994 1995 1996
7 13 11 9
42 48 45 15
107.60 101.57 100.00 30.40
ALL
14
150
339.57
150 (57) (27)
339.57 (128.67) (54.50)
(b) Large lines of credit used in ®nal analysisb Beginning sample 14 Confounding events 0 Unavailable on (2) CRSP Final sample (c) Banks granting lines Year/Bank Bank of Boston Bank of New York Bank of America Bankers Trust Chase Manhattan Chemical Bank Citibank First Chicago Morgan Nationsbank Wachovia Wells Fargo a
Line of credit value (US$ billion)
12 of credit by yearc 1993 1994 1.2 3.7 5.4 8.3 5.0 7.3 5.1 16.5 29.9 8.8 14.6 5.5 6.5 24.2 3.2 1.9
66
156.40
1995 2.5 17.5 29.7 9.1 9.7 45.5 12.0 1.0 28.8 6.5
1996 5.4 4.3 2.9 2.8 12.4 8.6 1.8
The number of banks do not add up to the ``ALL'' because many of the same banks granted lines of credit in several years. b Reasons for eleminating banks or lines of credit from the ®nal sample. c The amounts of lines of credit granted by each bank does not add up to the total granted for each year. The reason for this is that in many cases more than one of the banks was involved with granting the line of credit.
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US$339.57 billion. It also illustrates that there are few banks (14) in both the ®nancial position and with the expertise to act as a lead or co-lead in establishing a US$1 billion line of credit syndication. Each yearÕs number of banks do not add up to the total because many of the same banks are involved each year. Therefore, prior to eliminating confounding events, the sample consists of 14 banks and 150 lines of credit over US$1 billion during the time period 1993± 1996. Confounding events, in this portion of the study, are de®ned as any news article about the bank within a seven day window around the event date. The results of a search for confounding events are found in Table 2(b). Fifty-seven lines of credit are lost due to confounding events. In addition to confounding events, two banks representing 27 lines of credit are eliminated because their returns are not found in CRSP, these are both foreign banks. The ®nal 12 banks remaining in the sample represent all banks mentioned in the ``Late Breaking News'' section of the Gold Sheets. As would be expected, only the largest banks become involved as the lead or one of the co-lead banks on a US$1 billion line of credit. Table 2(c) lists the banks involved and the amounts of their lines of credit by year. The amounts do not add up to the total lines of credit granted, Table 2(b), because several of the lines of credit involved multiple banks. By any de®nition all of these banks are considered more reputable. Tests are conducted on the sample using Model (3). As shown in Table 3, the coecient on the variable of interest, the dummy, is positive and signi®cant. This indicates that when a bank grants a line of credit of this magnitude to a large ®rm, not only is a strong signal sent to the market about the borrower but a signal is also sent about the bank. It is also an indication that the bankÕs reaction is a result of the signal. If the reaction were caused either by incorporation of a new permanent income stream or the recognition that lines of credit are positive net present value transactions, the coecient for the bank would be substantially smaller.
Table 3 Results of event study of banksa
a
Variable
a
Rmt
Rtb t
Di
R2
Coecient (t-statistics)
0.0002 (0.953)
0.8329 (20.231)
ÿ0.2945 (ÿ16.848)
0.0044 (1.969)
0.1405
Rit ai b1i Rmt b2i Rtbt b3i Di ei . The ®nal sample from Table 2 of 12 banks and 66 lines of credit is used in the event study below. Model (3) is used to test the market reaction of the bankÕs stock on the date that the market becomes aware a line of credit is granted. * Signi®cant at the 0.01 level. ** Signi®cant at the 0.05 level.
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6. Summary This study investigates lines of credit to ascertain whether the market considers them value relevant for banks and impounds this information into the bankÕs stock price. Prior studies have shown that the market considers lines of credit value relevant for the borrower. A positive and signi®cant market reaction of the borrowerÕs stock occurs when the market becomes aware a line of credit is granted. This is the ®rst study to test whether there is a market reaction of the bankÕs stock when the bank grants a line of credit. A unique data set is compiled for this study. Observations are drawn from the set of all lines of credit granted during the years 1993±1996. This data gathering technique eliminates potential bias found in prior studies. To insure that the borrowers in this study react to the announcement that they are granted a line of credit in the same manner as borrowers in prior studies, similar tests are performed and prior results con®rmed. In addition to verifying prior works, these results are used to identify the precise date the market becomes aware a line of credit is granted. The ability to identify this date allows the event window to be one day. This increases the power of the tests over those using longer event windows by removing the noise of the non-event days. The current view of lines of credit is that they are a put option and, given the competitive nature of the banking industry, zero net present value projects. Therefore, no reaction is expected when the market becomes aware the bank has granted a large line of credit. This paper suggests two signaling hypotheses consistent with the bankÕs stock reacting positively. The announcement of a line of credit being granted by a bank can potentially produce two signals sent either individually or together. First, a signal is sent from the borrower that they are using the bank because they consider it strong and reliable. Second, a primary signal about the bankÕs future ®nancial position is indicated in several ways, all of which lead to a positive reaction. They include: a positive departure from competitive equilibrium in the area of lines of credit, potential increased future lending activity due to the bankÕs ability to maintain its competitiveness and in¯uential position in the allocation of credit, and it signals the bankÕs con®dence in their ability to fund any future obligations resulting from the exercise of lines of credit. The ®ndings show a positive and signi®cant market reaction of the bankÕs stock. These results suggests that a signal is sent to the market revealing the true nature of the bankÕs current and potential characteristics rather than impounding a speci®c transaction when a bank grants a large line of credit. The unique methodology used to identify the exact event date lends itself well to any other study where the event date of two entities are the same. Future research can take advantage of the new data source provided by the Loan Pricing Corporation to identify the actual time of day that the
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announcement becomes known by the market. This opens several avenues of research both for banks and borrowers.
Acknowledgements This paper represents a portion of my dissertation at the University of Oklahoma. I would like to thank my dissertation committee, Fran Ayres (Chair), Vic Bernard, Elizabeth Cunningham, Louis Ederington, Bart Ward and Lee Willinger for their many helpful suggestions and comments. This paper also bene®tted from the comments of participants at the 1997 Western American Accounting Association conference and two anonymous referees. I would also like to thank Crestar Bank, especially Sue Miller and Dawn Provost, for providing data used in this paper.
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