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The cost of debt of "sinful” activities

Posted by
Anita Belitz Krasniqi
Sunday, March 20, 2016 - 13:30

How do social norms affect bank lending decisions? Given the commonly high cost of equity capital for “sin firms”, for instance, are higher interest rates for bank loans also the norm for these firms?  And how can this be insightful for sustainable invesment? 

Research on firms involved in activities that some regard as being “‘sinful” (e.g., alcohol, tobacco, gambling, weapons, or pornography) is quite common in sustainable finance. This is probably due to the fact that an early form of sustainable finance, i.e. socially responsible investing, has its intellectual origins in religious investing. The idea behind socially responsible investing is that the investor aligns social-norms and investment decisions by, for instance, not investing in firms involved in certain activities. In fact, such investment screening has a long tradition among faith-based or religious investors, who have always sought to align their faith with their investment decisions. 

For instance, the Quakers refused to profit from weapons and slaves trade when they settled in North America and thus did not invest in companies engaged in such activities. In a similar spirit, the Methodist Church avoided investing in companies involved in the production of alcohol, tobacco, weapons and in gambling. In fact there is ample evidence of religious investing in other faiths as well, just think about the whole area of Islamic Finance.

The reluctance of some investors to invest in firms involved in certain activities has important implications. For instance, prior research[1] shows that the shareholder composition of alcohol and tobacco firms is fundamentally different from otherwise similar firms: in fact such firms have much lower institutional ownership, which is probably due to the fact that some norms-constrained institutions (e.g., university endowments or pension funds) refrain from investing in these companies. Because some investors refrain from investing in sin firms, these firms typically trade at lower equity valuations and consequently offer higher expected returns in the stock market.

While evidence on the higher cost of equity capital of sin firms is quite ample from research focusing on transparent stock markets, much less is known about how much sin firms pay when they finance their activities by relying on the less transparent and less scrutinized bank loan market. In other words, do sin firms also pay higher interest rates when they finance their activities using bank loans?

The paper Do Banks Really Care? Social Norms in Bank Lending by Chalabi, Guenster, and Kleimeier, which is featured at the Geneva Summit on Sustainable Finance, takes an interesting look at this issue by studying the loan terms of sin firms. In doing so, the authors examine whether social norms also affect bank lending decisions.

If banks are likely to be norms-constrained in the stock market due to public scrutiny, are they less likely to be norms-constrained in the less transparent debt markets? If so, sin firms should normally be able to obtain similar loan terms as comparable “non-sin” firms. If, however, banks refrain to lend to sin firms in the loan market, this should be evident by sin firms paying higher interest rates.  

Quite surprisingly, the authors find that sin firms pay lower interest rates on their loans than otherwise comparable non-sin firms.

This discovery is important on at least two fronts. First of all it indicates that institutions that are norms-constrained in public markets might be so to a lesser extent in less transparent markets. Probably even more importantly, the study also shows that higher financing costs in equity markets for sin firms are undone by the lower interest rates on loans from the banking sector. And, even though sin firms are considered quite the reverse of sustainable development activities, the later implication suggests that the banking sector could potentially play an important role in offsetting higher costs of equity finance for activities that are conducive to sustainable development.

[1] Hong, Harrison, and Marcin Kacperczyk. "The price of sin: The effects of social norms on markets." Journal of Financial Economics 93.1 (2009): 15-36.

Faculty expertise provided by: Prof. Philipp Krueger