Is unsystematic risk priced in bank loan contracts?

Abstract

We demonstrate that a firm's unsystematic risk is positively related to its cost of bank debt. A borrower's unsystematic risk needs to be costly monitored by the lender and some of this cost is included in the bank contract. A one SD increase in unsystematic risk results in a 14.0–19.5% increase in the cost of the loan, or 24–34 basis points for the median loan. Our results complement recent literature about the relevance of unsystematic risk and its effect on the cost of capital of corporations.

Keywords:

• unsystematic risk
• U.S. bank loans
• cost of debt

JEL Classification:

• G1
• G2
• G21

Notes

¹ Merton (1987) offers a partial explanation based on incomplete information and investor under-diversification.

² Diamond (1984) states that the ‘intermediary monitors firm specific information.’ (p. 403); at equilibrium we can expect banks to pass through some of these monitoring costs to borrowers.

³ We thank professor Ken French for making these factors available in his website: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html