What is the reciprocity effect in loan syndication?

Lead arrangers commonly choose participants with similar lending specialization and borrower monitoring capability.  While the participant lenders “free-ride” on the due diligence and monitoring performed by the lead arrangers, they mutually benefit from each other’s monitoring effort and shared information.  The reciprocity effect becomes sustainable as lead arrangers persistently monitor their borrowers and share this information with participant lenders.

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Reciprocity reduces moral hazard as generally reflected in:

1. Lead arrangers retaining a smaller share of the loans they lead when also participating in loans led by their participant lenders;
2. Borrowers being charged lower interest due to a decrease in the risk-adjusted interest rate; and
3. A lower probability of loan default among the loans.

Although syndicate strategy is the responsibility of the lead arrangers, they will generally accommodate borrower wishes as to the syndication strategy and the invitation of certain banks to participate as co-underwriters and participant lenders.