Overvaluation and the cost of bank debt

•Banks can detect overvaluation and increase the price of bank loans.•Firm-specific overvaluation is positively correlated with the bank loan spread.•The positive overvaluation-spread relationship is salient for firms subject to severe information asymmetry.•The positive overvaluation-spread relationship is attenuated for firms that had seasoned equity offerings prior to the loan initiation.•High bank loan costs reduce overvaluation and the overvaluation-induced agency costs.

Jensen (2005) suggests that overvalued equity increases agency costs, which are difficult to control through existing market mechanisms. In the present study, we document that banks can detect overvaluation and increase the price of bank loans to compensate for the engendered agency costs. On the basis of 17,309 firm-year observations of Taiwan-listed firms for the 2002-2012 period, we find that firm-specific overvaluation (the first component of the decomposition model proposed by Rhodes-Kropf, Robinson and Viswanathan (2005)) is positively correlated with the bank loan spread. In addition, the positive overvaluation-spread relationship is more conspicuous for firms associated with severe information asymmetry but attenuated for firms that had seasoned equity offerings prior to the loan initiation. Finally, we document that high bank loan costs reduce overvaluation and overvaluation-induced agency costs.