Passive ownership increases loan spreads, prompting bank monitoring

A new Bank for International Settlements (BIS) working paper finds that increased passive ownership in publicly traded firms leads to higher loan spreads. This effect reflects both reduced shareholder oversight and banks' intensified monitoring efforts.

The rising cost of passive ownership

The study reveals that loan spreads increase significantly with a higher share of passive index fund investors in a firm's ownership structure.

Using granular syndicated loan data for U.S. public firms from 2006 to 2022, and leveraging Russell index reconstitutions as an exogenous source of variation, the researchers find a statistically significant rise in loan spreads.

Firms experiencing an increase in passive ownership, such as those downgraded in Russell index classifications, see loan spreads increase by an estimated 12 percent, equating to around 20 basis points from the sample average of 175 basis points.

This finding supports the hypothesis that a shift towards passive shareholders necessitates increased compensation for creditors due to perceived higher risk.

The effect is particularly pronounced in firms where shareholder oversight traditionally has a greater impact on corporate governance, suggesting that the displacement of active monitoring by passive investors is consequential for financing costs.

Banks intensify their monitoring

The paper explores the economic mechanisms behind higher loan spreads, finding evidence consistent with both increased firm risk and enhanced bank monitoring.

Firms with greater passive ownership tend to become riskier, as indicated by higher expected default probabilities and increased stock price volatility.

Banks respond by requiring collateral more frequently and imposing stricter financial covenant terms, leading to higher probabilities of covenant violations at loan initiation.

While changes in firm risk are a modest mediator of the overall effect, the study observes a significant increase in specific monitoring provisions within loan contracts, such as loan-to-value (LTV) covenants and field examinations.

The loan share of lead arrangers, who typically perform primary monitoring, also rises with passive investor share, indicating a direct response by banks to compensate for reduced shareholder oversight.

These results remain robust to various extensions and robustness tests, including ruling out bank market power as a driver.

Passive investing's hidden costs

This research provides crucial empirical evidence challenging the assumption that passive ownership is neutral for corporate governance and credit markets.

It highlights a significant trade-off: while passive funds offer diversification, they may inadvertently increase firms' financing costs by diluting active shareholder oversight.

For banks, this implies a need for more intensive and costly monitoring, underscoring the broader implications for financial stability and corporate credit allocation.