Financial Statements as Monitoring Mechanisms: Evidence from Small Commercial Loans

• In Event: Use of Accounting in Debt

Abstract

We use a proprietary database of bank information requests to small commercial borrowers to examine the role of financial statements in loan monitoring. Our findings are threefold. First, consistent with Diamond (1991), we find an inverse U-shaped relation between a bank’s financial statement requests and a borrower’s credit risk—i.e., firms with credit ratings toward the middle of the spectrum are most intensively monitored—while financial statement requests are monotonically decreasing in relationship length. Second, we find that while collateral and financial statements are negatively related generally, bank requests for interim financial statements are positively associated with collateral, highlighting a collateral monitoring role of timely financial statements. Finally, we present novel evidence that tax returns serve as a substitute for financial information, particularly when a borrower has a high (low) level of intangibles (asset intensity); however, tax returns serve as complements when monitoring is particularly beneficial, presenting unique evidence that banks value the implicit verification role of the government. Collectively, our results provide new evidence of the manner in which financial statements are informative in loan monitoring.

Authors

• Michael Minnis, The University of Chicago

• Andrew Sutherland, The University of Chicago