Apart from providing valuable monitoring functions, banks also facilitate low-cost recontracting in defaults, and low-cost restructuring can, in turn, encourage borrowers to resort to strategic default. These functions, according to Esty and Megginson (2003), generate three empirical forecasts on syndicated lending on how banks adjust the size and concentration of the syndicate structure in response to legal risk to facilitate their governance roles.1
In the first forecast, the monitoring hypothesis predicts that, when bank monitoring is crucial, banks will form more concentrated syndicates because fewer participating banks will be holding large individual shares of the loan. Fundamentally, bank monitoring is important when the level of legal risk is significantly high, since there is a greater probability for misappropriation of cash flows in countries with high legal risk. Banks, however, have fewer legal rights and cannot rely on the rule of law to enforce contracts in this case. Thus, the opposite is expected: banks will hold larger shares of the loan or lending syndicates will become more concentrated in countries with low legal risk.
In the second forecast, the low-cost recontracting hypothesis predicts that, when economic default is more likely because of financial and macroeconomic conditions, banks will form more concentrated loan syndicates to reduce recontracting costs. Low-cost recontracting, similar to monitoring, relies on the efficiency of legal systems to enforce contracts. And like the monitoring hypothesis, the low-cost recontracting hypothesis predicts that banks will form more concentrated syndicates in countries with low legal risk.
In the third forecast, the deterrence hypothesis predicts an inverse association between legal risk and loan-syndicate concentration. Banks try to avoid strategic default by choosing more diffuse loan structures because it is costlier to default this way. So, banks make it more expensive and burdensome to default, knowing that higher legal risk results in the weak enforcement of contracts.
Esty and Megginson's (2003) empirical findings suggest that bank lenders tend to create smaller and more concentrated syndicates to facilitate monitoring and low-cost contracting in countries with strong legal environments. In other words, low legal risk or a stronger rule of law is positively associated with a higher concentration of debt. That said, bank lenders tend to create larger and more diffuse syndicates to discourage strategic default when they cannot rely on the courts for legal enforcement mechanisms.