Can lenders discern managerial ability from luck? Evidence from bank loan contracts

Abstract

We investigate the effect of managerial ability versus luck on bank loan contracting. Borrowers showing a persistently superior managerial ability over previous years (more likely due to ability) enjoy a lower loan spread, while borrowers showing a temporary superior managerial ability (more likely due to luck) do not enjoy any spread reduction. This finding suggests that banks can discern ability from luck when pricing a loan. Firms with high-ability managers are more likely to continue their prior lower loan spread. The spread-reduction effect of managerial ability is stronger for firms with weak governance structures or poor stakeholder relationships, corroborating the notion that better managerial ability alleviates borrowers�� agency and information risks. We also find that well governed banks are better able to price governance into their borrowers�� loans, which helps explain why good governance enhances bank value. ? 2017 Elsevier B.V.