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facilitates accurate pricing of securities subject to adverse selection problems. This section presents empirical studies that examine the choice of borrowing privately versus publicly for firms subject to greater adverse selection problems. In addition, it presents a number of studies that investigate the effect of bank loan announcements on stock market returns. Lastly, it present evidence suggesting that investors in capital markets value banking relationships.

A number of studies examine the choice of borrowing from private or public sources. The evidence suggests that firms facing significant adverse selection have a preference for borrowing privately. The main assumption underlying this notion is that banks have a comparative advantage in valuing securities. Hadlock and James (2002) investigate the influence of possible adverse selection costs on the choice of financing through a bank loans versus public securities (both debt and equity). They find that stock return volatility is positively and significantly related to the probability of having a bank loan. This finding suggests that firms subject to high information asymmetry, and possible mis-valuation, prefer to contract with an informed lender. In addition, the authors calculate the cumulative stock return over the last 12 months to approximate possible mis-valuation, the higher the cumulative return the lower the mis-pricing. They propose that firms with mis-priced stock are more likely to use bank financing. The authors find that the firm’s cumulative return is negatively related to the probability of announcing a bank loan. This evidence suggests that firms with favourable private information and mis-priced equity prefer to borrow from banks since the latter will value the loan accurately. Krishnaswami et al., (1999) document similar evidence on the relation between undervalued firms and the choice of bank debt. They find that firms subject to high information asymmetry and with positive earnings surprises have a larger proportion of private debt in their debt structure.

In addition, market participants, including shareholders, expect that banks will accurately value loans given the bank’s informational advantage. Therefore, the

(compared to a negative stock price reaction if the market expects that banks will mis- value the loan). As James (1987) suggests, bank debt can be viewed as an inside source of capital similar to financial slack in the context of Myers and Majluf’s (1984) pecking order of financing sources. Moreover, the announcement of new bank loans could result in a positive market reaction since it may convey a positive signal about the prospects of the firm. James (1987) investigates a sample of 80 announcements of bank loan agreements and documents a significant positive announcement effect. He also documents non-positive responses to the announcements of other types of securities including debt private placements (negative and significant) and public debt offerings (negative but insignificant).4

Lummer and McConnell (1989) suggest that the bank learns about the firm through continuing lending relationships. Therefore, the information the bank learns about the firm is revealed when a loan is renewed or restructured but not when the bank contracts with the firm for the first time. Lummer and McConnell classify bank loans into new bank loan agreements and revisions to agreements already in place. In addition, they classify announcements relating to bank agreements in place into announcements containing positive information and those containing negative information. Their findings indicate that the announcements of new agreements are not associated with a significant market reaction. The market reaction to the announcements relating to existing agreements, on the other hand, depends on the type of information contained in the announcement. The market reaction for existing agreements is positive for favourable renewals and negative for renewals with negative information.

Further, there is evidence suggesting that the information advantage of bank debt extends to other agents in capital markets because banks provide signals about the quality of the firm through its monitoring and certification activities. A number of studies examine the effect of banking relationships on equity returns. James & Wier (1990) examine how the presence of banking relationship affects the underpricing associated with initial public offerings (IPO) of equity. They investigate the

4 _{The latter finding is supported in Hadlock & James (2002) who document that the announcement of}

seasoned public debt issues is associated with a significant but small negative market reaction; and Datta, Iskandar-Datta, & Patel (2002) who document a significant negative market reaction for firm issuing

underpricing the firm experience when it issues an IPO for companies with a borrowing relationship, as reported in the firm’s prospectus, and those without it. The authors document that the average initial return for the 455 firms in their sample with previously established borrowing relationships is 9%, while the average for the remaining 94 firms without debt is 31%. Similarly, Slovin & Young (1990) find that, for a sample of 316 initial public offering, the presence of bank debt is negatively and significantly related to the ratio of the first reported closing bid to the offering. This finding supports the evidence in James & Wier (1990) in that IPO firms experience less underpricing when they have a banking relationship. Slovin, Sushka, & Hudson (1990) investigate the market reaction to announcements of seasoned stock offerings. They find that the stock price reaction is significantly more negative for firms without bank debt compared to firms with the largest debt ratios in their sample.

However, there is little research on the value of banking relationships in the public debt markets, with the exception of Datta, Iskandar-Datta, & Patel (1999) who investigate the effect of the presence of a bank loan at the time of issuing public debt on bonds’ yield spreads. They estimate a model of the cost of debt for initial public debt offers. The authors select a sample of 98 initial public offers of straight debt issued over the period 1971-1994. Out of their initial sample, 64 firms had bank debt at the time of bond issue while the remaining 34 firms did not. They find that the presence of a bank loan at the time of issuing public debt bank relation reduces the spread by around 84 basis points.