-~4-

and have agreed to raise a loan on specific terms. Additional lead managers
may have to be brought in subsequently if the loan is to be successfully
marketed. The lead managers must decide what other banks to try to bring into
the syndicate, either as both underwriters and providers of funds (often -called
“managers” or “co-managers") or merely as providers of funds (the non-managing
“participants").

The distinctive activity of the lead managers, and the additional
risk and costs involved in underwriting as opposed to mere provision of funds,
require differential returns. This is accomplished through the fee structure.
While all the lenders share in the total fee, they do so unequally. In part,
of course, the division of the fee depends on the amount of funds each bank
provides. But in addition, some portion of the fee is reserved to compensate
the lead managers for their particular function as organizers, while another
part of the fee compensates all the various levels of managers for bearing the
underwriting risk. The extent to which the fees are shared by the lead
managers with other banks in the syndicate often depends upon the difficulty
the lead managers encounter in marketing the credit to lower-level managers and
non-managing participants. Having a pool of fee income to distribute to
potential participants is a flexible tool for lead managers to use to increase
participation in a loan without having to revise the spread.

III. The Data

The study examines data on 183 syndicated Eurocredits to
public-sector borrowers announced in the three years 1981-83. The 183 credits
are all those to public-sector borrowers described in AGEFI International
Financing Review, for the years covered, that have the following two

characteristics: (1) complete information on the total front-end fee is given


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bank officers to shift loan returns from the future to the present by the use
of fees, are seen to have been of large weight in the determination of fee
levels.

The coefficient of the spread variable, amounting to 0.15, indicates
that every 100 basis points of spread is associated with a level of fees of 15
basis points. Table 2 is a matrix showing the importance of the spread in
determining fees on Eurocredits of three different maturities. At the mean
observation, i.e., a credit with a mean spread of 86 basis points and a mean
maturity of 7.4 years, the spread accounts for about three-fifths of the
estimated level of front-end fees. For credits with higher spreads, the
impact of the spread in the determination of the fee in greater, both
absolutely and relatively, while with lower spreads the importance of the

spread as a determinant of the fee diminishes.

Table 2. Estimated Annual Average Fee

for Selected Maturities and spreadsl/
(in basis points)

Loan Maturity (years)

5 74 10
Spread over LIBOR
50 basis points:
(1) estimated fee, of which: 19.2 15.8 12.1
(2) contribution of spread 7.5 7.5 7.5
(3) contribution of other factors 11.7 8.3 4.6
86 basis points:
(1) estimated fee, of which: 24.6 21.2 17.5
(2) contribution of spread 12.9 12.9 12.9
(3) contribution of other factors 11.7 8.3 4.6
125 basis points
(1) estimated fee, of which: 30.5 27.1 23.4
(2) contribution of spread 18.8 18.8 18.8
(3) contribution of other factors 11.7 8.3 4.6

1/ Fee is on an interest-equivalent basis


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Table 1. Front-End Fees and LIBOR Spreads on 183 Eurocurrency
Credits Arranged in 1981-83
(percent per annum)

Interest equival- Total return Fee as
ent annual Spread over to lender percentage of
average fee LIBOR (1) + (2) total return
Borrowing Country
(number of credits in parentheses)
I. Industrial countries (744!
Average for group 015 255 -70 22
Averages for selected countries:2/
France (6) 07 43 +49 13
Denmark (4) +13 245 +69 22
Greece (10) 14 255 58 21
Italy (19) 16 055 +76 22
Spain (20) 217 59 71 22
Portugal (5) 19 265 84 23
Others (10) 17 55 +72 24
II. Developing countries (109)
Average for group 224 1.07 1.32 19

Averages for selected count ries2/

Indonesia (4) ell AL OL 21
Colombia (4) 17 294 1.11 16
Korea (13) +18 +62 80 23
Venezuela (15) +20 69 +90 23
Mexico (16) 221 +72 +93 22
Philippines (4) 222 82 1.03 21
Chile (5) 224 1.31 1.54 15
Peru (3) 224 1.33 1.57 15
Argentina (8) 37 1.32 1.68 22
Brazil (22) 40 2.07 2.47 16
Other non-Latin

American

countries (12) 212 40 252 23
Other Latin

American

Countries (3) +27 1.59 1.85 14

III. All credits in sample (183)

Average 21 86 1.07 19

i Includes a $1.3 billion credit to the European Community in June 1983.
2/ Countries shown individually are those arranging three or more credits.


-5-

in the source publication, and (2) the loan is priced over LIBOR. Complete
information on fees is available for only a minority of all loans. Some loans
are priced over the U.S. prime rate or a U.S. CD rate, over the long-term bank
lending rate in Japan, or in other ways, but these had to be excluded because
for the purposes of this study the pricing procedure must be the same from loan
to loan and LIBOR is the most commonly used basis.t/ The credits examined
here amounted to $74 billion, equivalent to 25 percent of all announced medium-
term Eurocredits, in the period covered, shown in Morgan Guaranty Trust Co.
World Financial Markets .2/

The data are arranged in Table 1 to show average levels of front-end
fees for different countries, and how these compare with the levels of spreads
over LIBOR. As noted earlier, the front-end fees are expressed as interest
equivalents, i.e., as an estimated annual average flow, over the life of the
loan, having a present value equal to that of the fee actually paid. This
procedure is used in order to make fees, which are paid up-front, comparable
with interest spreads. The discount rate used to make the adjustment to the
interest-equivalent basis is as follows: (1) for loans of one and five years,
the average Eurodollar deposit rate of comparable maturity in the quarter when
the loan was arranged; (2) for other loans, the average yield on the U.S.
Treasury bond of closest maturity, adjusted by the amount of the difference
between the 5-year bond yield and the 5-year Eurodollar rate, in the quarter
when the loan was arranged.

The (unweighted) average front-end fee on the 183 credits under
examination was equivalent to .21 percent per annum. But the average for

industrial countries (.15 percent) was well below that for developing

i Some loans give the lender an option to price over LIBOR or another base
Tate. Such loans are included in the study and the LIBOR spread is used.

2/ The true percentage of coverage is higher than 25 percent because the $74
Dillion is based on initial amounts sought while the Morgan Guaranty figures
include changes after syndication is begun, nearly all of which were increases.


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Coefficient
Estimated Coatribution
value t-statistic to R2
Constant (in basis points) 18.88 11.85 -
Explanatory variables:
1. Spread over LIBOR
(in basis points) 0.15 19.09 59
2. Maturity of loan
(in years) 1.43 7.71 06
3. Loan arranged in five quarters
subsequent to Mexican announce-
ment (dummy variable) -3.91 4.46 03
4. Developing country outside
Latin America
(dummy variable) 3.12 2.38 01
5. Argentine bridge loan
(dummy variable) 43.28 9.03 08

R-squared (corrected) = .83
Standard error of the regression = 4.83

The estimated coefficient values in this regression are all
significant at the .01 leve1.1/
In terms of its role in explaining the variations in the fee, the
most important determinant of the fee was the spread over LIBOR. A rise in
the fee was associated with a rise in the spread. Spreads tend to be an
indicator of the degree of risk that the lending banks attach to tire loan, and
their close relationship with fees indicates that fee levels also are a
reflection of the risk as perceived by the syndicate members. To an important
degree, fees augment total compensation to lenders, which is based largerly on

lenders' perceptions of risks. The factors that motivate borrowers to hold

down highly visible spreads by paying less-visible fees, and that induce

1/ This regression was performed under a Cochrane-Orcutt transformation, to
@liminate autocorrelation of residuals. Under the transformation the final
value of rho is .285, with a t-statistic of 4.01. The measure of
multicollinearity among the explanatory variables is less than .05, indicating
very little multicollinearity.


International Finance Discussion Papers

Number 250
October 1984

THE DETERMINATION OF FRONT-END FEES ON
SYNDICATED EUROCURRENCY CREDITS

by

Rodney H. Mills and Henry S. Terrell

NCTE: International Finance Discussion Papers are preliminary materials
circulated to stimulate discussion and critical comment. References in
publications to International Finance Discussion Papers (other than an
acknowledgment by a writer that he has had access to unpublished materials)
should be cleared with the author or authors.


-ll-

spreading the "fixed" fee for managerial activity over an increasing number of
years dominated the effect of increasing risk associated with lengthening
maturity. The constant term amounts to 18.9 basis points. The combined
impact on the annual average fee of these two factors was as follows for loans
of 5, 7.4 (sample average), and 10 years maturity (measured in basis points):

Maturity (years)

5 7.4 10
Impact of constant 18.9 18.9 18.9
Impact of maturity variable -6.2 -10.6 14.3
Combined impact 11.7 8.3 4.6

As can be seen, for the average maturity of 7.4 years the estimated
portion of the overall annual average fee accounted for by factors other than
the spread was 8.3 basis points. As was shown in Table 2, for loans of that
average maturity that carried an average spread over LIBOR of 86 basis points,
the estimated total annual average fee was 21.2 basis points, of which the
factors other than the spread contributed about 40 percent. The contribution
of these factors decreases as the maturity lengthens and increases as the
maturity shortens.

The final three explanatory factors represented by dummies
variables, relate to special loan circumstances. The first dummy variable is
for loans made after the third quarter of 1982. The estimated coefficient of
this dummy is about -3.9 basis points, indicating that, after allowing for the
effect of the other variables, the fee tended to be 3.9 basis points lower in
the firal five quarters of the 1981-83 observation period than on average over
the twelve quarters. The apparent difference in behavior in the final five
quarters may have been a consequence of the Mexican liquidity crisis in the
summer of 1982, and the beginning of banks' reduced enthusiasm for lending to

developing countries, especially Latin America. As banks' attitudes changed,


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The other important economic factors determining the annualized
value of front-end fees are (1) the constant term, and (2) the maturity of the
loan. The constant term can be interpreted as a measure of the amount of fee
required to compensate the syndicate managers for their organizational and
underwriting activities, including compensation reserved to be distributed in
a flexible manner if terms need to be improved to market a loan. ‘The constant
term is close to 20 basis points. This suggests that, for syndicat:ed credits
of five years -- a maturity below which few credits are arranged ~-- the
compensation to the syndicate managers might, on average, total close to one
percent of the loan. However, the constant and the maturity variable should
be evaluated together.

The coefficient of the maturity variable reflects the impact of two
influences working in opposite directions. First, it reflects the effect of
spreading, over the number of years of the loan, the fee payment that
compensates the managers for their activity. The impact on the annual
average fee of this spreading effect is of course negative ~- the longer the
maturity of the loan, the lower the annual average compensation for managerial
activity. Second, the coefficient of the maturity variable reflects the
increasing risk, as the maturity lengthens, of being committed to provide
funds to the borrower. The impact on the annual average fee of this risk
effect of the maturity is positive, i.e., the fee tends to rise as the
maturity lengthens. The risk associated with fluctuating interest rates is of
course largely eliminated by use of the -base interest rate, which is reset at
periodic intervals.

In the regression results, the maturity variable (measured in years)

has a coefficient of ~1.43. The negative sign shows that the effect of


-7-

countries (.24 percent). Within the group of industrial countries, the
average annual interest-equivalent fee for France (.07 percent) was much lower
than that for the others. Among developing countries, the average ranged from
«ll percent for Indonesia to .40 percent for Brazil.

The higher fees for developing countries (as a goup) compared with
industrial countries was associated with a generally higher level of spreads
for the former. And within the two groups, from country to country there was
some evident correlation between fees and spreads. However, it is also
apparent from column 4 of the table that factors other than spreads also
affected fee levels. The share of the fee in the total annual return from fee
and spread varied greatly. The fee share was lower for the developing
countries than for industrial countries. In that group the fee share tended
to be lower for the Latin American countries than for the others, while among
industrial countries the fee share for France was notably low.

Iv. Determinants of Fee Levels

On the basis of the 183 credits under study, 83 percent of the
variation in the level of the annual average front-end fee can be explained
using five explanatory variables. The regression of the fee (interest-
equivalent basis, measured in basis points) on the explanatory variables

yields the following results:


II. The Reasons for Fees

Front-end fees are paid for what appear to be two basic reasons: (1)
borrowers or lenders, or both, desire to utilize fees to augment the spread
over the base interest rate; and (2) the lending banks in a given loan are not
a homogeneous group but perform various functions that require varying rates of
compensation.

Borrowers are anxious to receive credit for negotiating loans on the
lowest possible terms. Because spreads on Eurocredits receive more publicity
than fees, which in fact are not publicized in the majority of cases, borrowers
have an interest in concealing the true costs of their loans. Consequently,
borrowers place greater emphasis on minimizing spreads, doing so by offering to
pay the banks a higher front-end fee than otherwise in return for some
reduction in spread.

Bankers themselves may prefer to receive fee income in lieu of some
part cf an otherwise higher spread. Income received immediately is certain,
whereas income scheduled to be received in the future is to some degree
uncertain. This risk factor would tend to raise fees relative to spreads. In
addition, there is a widespread feeling that bank officers may have had
incentives to prefer fee income over spread income because this shifts bank
income from the future to the present, to the potential benefit of those
officers' personal recognition and rewards /

In addition to the general preferences of both borrowers and lenders
for a fee structure, some level of fees would be paid because of the diversity
of the roles of the various lending banks in the syndicate. The syndicate is

organized by one or more lead managers who have negotiated with the borrower

i/ For U.S.-chartered banks, new regulations effective in 1984 limit the extent
to which, in its accounting, a bank may consider front-end fees as income as
soon és received. On restructured loans, beginning March 29, 1984 a bank must
amortize over the life of the loan all fees in excess of administrative costs.
On other loans, effective June 30, 1984 a bank must amortize over the life of
the lcan all fees considered as an “adjustment to yield," defined as the
largest fee received by a non~managing loan participant.


-2-

spread and fee.L/ One of the outstanding characteristics of the terms of

these loans is the variability shown by the level of the front-end fee and by
the share of the fee in the total return. On an interest-equivalent basis, the
annual average level of the fee income ranges from a low of only six basis
points per annum to a high of 83 basis points, while as a share of the total
return from spread and fee the fee share ranges from a low of nine percent to a
high of 43 percent.

The purpose of this study is to explain the factors that determined
the levels of the front-end fees on syndicated Euroloans that were arranged in
the three years 1981-83. The main findings of the study are as follows:

(1) A close statistical relationship exists between the level of fees
and the level of spreads. This relationship indicates that fees are utilized
to raise the level of total compensation to banks in a very consistant manner.

(2) Fee income also appears to function as compensation to the
syndicate managers for costs associated with their organizational and
underwriting activities. The "fixed cost" aspect of this fee income to banks
is indicated by the fact that the annualized value of the fee declines as the
maturity of the loan increases.

(3) Fees tended to be somewhat lower after the Mexican crisis in
1982-QIII, probably because of increase of competition among syndicate
managers for a reduced volume of loan business,

(4) Developing countries outside Latin America tended on average to
Pay somewhat higher fees than other countries, after taking account of other

factors.

i/ In this calculation, actual fees have been adjusted to an interest-
equivalent basis. As described in more detail below, fees on an
interest-equivalent basis are an estimated stream of annual average payments,
over the life of the loan, having a present value equal to the fees actually
received.


The Determination of Front-End Fees on Syndicated Eurocurrency Credits

by

Rodney H. Mills and Henry S. Terrell*

I. Introduction and Summary

In the Eurocurrency market the total return to a lending bank on
syndicated loans regularly includes two components. One ‘is a continuing return
in the form of a spread (also called margin) over a base interest rate,
generally either the London interbank offer rate (LIBOR) for the currency
involved, the U.S. prime rate or a U.S. CD rate (for a dollar-denominated loan
with iarge participation by U.S. banks), or the Japanese bank long-term lending
rate (for a yen-denominated loan with large participation by Japanese banks).
The other component is a front-end fee, a payment that is normally made by the
borrower in a lump sum soon after the loan agreement is signed.l/ The
base interest rate to which the spread is added is usually an approximation of
the marginal cost of funds to a reference group of banks in the syndicate.

While the spread over the base interest rate constitutes the major
part of the total return to the lender on syndicated Eurocurrency credits, the
share accounted for by front-end fees is nevertheless important. On syndicated
loans arranged in 1981-83 with an interest spread over LIBOR and for which the
front-end fee data are available, the front-end fee accounted for an average of

almost: 20 percent of the combined annual average return to the lender from both

%*/ Senior Economist and Chief, International Banking Section, Division of
International Finance, Board of Governors of the Federal Reserve System.

This paper represents the views of the authors and should not be interpreted

as reflecting the views of the Board of Governors of the Federal Reserve System
or members of its staff.

1/ Under certain circumstances, lenders may also earn fees from other sources.
For example, if the loan is not disbursed by a given date the bank will usually
earn a commitment fee.


-12-

smaller banks reduced their participation in syndicated loans. The syndicates
became smaller, and the portion of the syndicates made up of lower-level
managers and non-managing participants tended to diminish considerably while
the share of lead managers grew. Competition among prospective lead managers
(generally the larger banks) for the reduced volume of syndication business
Probably had the effect of reducing the fees paid to them for their particular
managerial activity, thus reducing fees as a whole. It is true that: the new
loans to Latin American borrowers since the Mexican crisis have involved
increased administrative costs, because they have been part of “packages” that
included reschedulings, maintenance of trade credits, or IMF drawings, but
these added administrative costs have been charged to the borrowers separately
in addition to front-end fees.

The second dummy variable is for loans to developing countries
outside Latin America. The estimated coefficient of about 3.1 basis points
indicates that loans to that group of countries tended, ceteris paribus, to
have slightly higher fees than average. These countries in general, over the
full three years covered by the data, may have felt greater need than the
other countries to “disguise” their true borrowing costs by offering to pay
higher fees than otherwise in return for some reduction of spreads.

The last dummy variable applies to only one loan, the $1.1] billion
14-month “bridge loan” to Argentina on which terms were definitively arranged
in December 1982. The loan carried a spread over LIBOR of 1-5/8 percent, with
front-end fees of 83 basis points on an interest-equivalent basis. The
regression estimates a fee for this loan of only 42 points. The very high fee
actually paid apparently reflected an exaggerated substitution of fee income
for spread income caused by unusual considerations, since the next highest
difference between actual and estimated fee on the remaining 182 credits was

only 17 points.