Credit Cycles and Financial Statement Verification

• In Event: Financial Institutions and Debt Contracting

Abstract

We use the US construction industry during the years 2002 to 2011 as a setting to examine whether credit cycles affect the use of financial statement verification in debt financing. Our estimates reveal that banks reduced their collection of unqualified audited financial statements from construction firms by 35% during the housing boom period before 2008, relative to firms in other industries. This reduction was most severe in the US regions that experienced the most significant construction loan growth and most severe ex post loan losses. These trends reversed during the subsequent housing crisis in 2008 to 2011 when the credit cycle reversed. Moreover, using bank and firm level data we find a strong negative (positive) relation between audited financial statements and subsequent loan losses (construction firm survival). Collectively, our results provide empirical support for theories predicting that banks reduce lending standards during credit booms and that credit fluctuations cause temporal shifts in the overall level of financial statement verification in the economy. In addition, temporal shifts in verification are related to bank loan portfolio quality and borrower performance.

Authors

• Petro Lisowsky, University of Illinois at Urbana–Champaign

• Michael Minnis, The University of Chicago

• Andrew Sutherland, The University of Chicago