Banking on Experience. Capital Reallocation, Asset Knowledge, and the Structure of Credit Contracts

The firm sector continuously engages in the reallocation of physical capital. We study the implications for credit market outcomes of banks' engagement in borrowing firms' capital reallocation. We develop a model in which banks' experience with the reallocation opportunities of physical capital raises their ability to recover liquidation values after firm defaults and asset reallocations, diluting banks' incentives to monitor borrowers. To test the model, we then construct an empirical measure of banks' engagement in capital reallocation using US loan-level data matched with firm-level data on capital asset transactions. We find that, unlike lending relationships and experience with co-lenders, capital allocation engagement dilutes banks' monitoring incentives, calling for larger involvement in loan syndication.