Performance Pricing in Bank Debt Contracts

Performance pricing links the interest rate spread on bank debt to a borrower's performance via two options. It gives borrowers an option to reduce interest rates if credit quality improves, and it gives lenders an option to receive higher interest rates if credit quality deteriorates. Contracts with interest-decreasing performance pricing are more common when prepayment is more likely or more costly and when adverse selection costs are higher, and are less common when multiple measures of performance are better predictors of credit quality. Interest-increasing performance pricing is more common when lenders offer reductions in interest rates to add this provision, when the probability of a downgrade is more likely, and when moral hazard costs are higher. This paper also finds that lenders charge a lower rate when interest-increasing performance pricing provisions are included in the contract.

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