Agency costs, bank specialness and renegotiation

This thesis proposes, for the first time, the yield spread between public bonds and bank loans of the same firm (the Bond-Bank spread) as a measure of compensation for agency costs that cannot be mitigated by bondholders but can be mitigated by banks due to their ability to monitor the firm and renegotiate the loan. The bond-bank spread thus can also be interpreted as a measure of bank uniqueness that gives rise to its existence. Alternatively, it can be interpreted as the option premium paid ex-ante by the bank in order to have the ability to renegotiate the loan in the future.; Essay 1 constructs a theoretical model of debt pricing and choice, facing the firm. The tradeoff between firm moral hazard and bank opportunism, leads to co-existence of relationship debt (bank loans) and uninformed debt (bonds) in its capital structure. The key features of the model are endogenous monitoring by banks and co-existence of bank loans and bonds in the firm's capital structure. Contrary to common concerns, bank oversiglit actually increases in the presence of bonds.; Essay 2 develops the pricing implications of the model constructed in Essay 1. In particular it derives two testable predictions related to the bond-bank spread: (1) The Bond-Bank spread is positive for all firms; (2) The bond bank spread is negative for high quality firms and positive for low quality firms depending on the relative importance of monitoring costs and bank opportunism respectively. It further considers 2 extensions to the basic model (1) Multiple banking relationships are explicitly introduced and (2) Bargaining power of the firm in its negotiations with the bank, which was hitherto exogenous is explicitly endogenized.; Essay 3 constructs a large and unique data set of bond and bank yields, for the same firm at the same point in time, matched by Credit Rating, Seniority, Maturity and adjusted for collateral differences, and shows that the Bond-Bank Spread is negative for high credit quality firms and positive for low credit quality firms. Using another sample in which collateral is matched rather than adjusted, it is shown that the bond-bank spread is positive for all firms. Both these results are consistent with the theoretical model. Applying a new econometric methodology on matching developed by Heckman et al(1998), the results of the sample are confirmed. The Bond-Bank Spread is about -76 basis points for A borrowers, 75 and 53 basis points for BBB and BB borrowers, increasing to 173 and 335 basis points for the B and CCC rated borrowers respectively. Thus agency costs or the specialness of banks seem to be important for BBB and below investment grade firms across the credit spectrum.