Accounting Information and Risk Shifting with Asymmetrically Informed Creditors

Should financial reporting regulations be procyclical or countercyclical, with greater scrutiny applied during economic downturns or boom periods? While this question has received much attention in the aftermath of the recent financial crises, often directed at the issue of how particular accounting choices (e.g., fair value accounting) affect equity markets, it remains largely unexplored in debt markets. In a forthcoming article in the Journal of Accounting and Economics, we study the consequences of accounting quality for debt contracting when banks compete to extend loans. Specifically, we ask how the availability of information, public or private, about the economic condition of a potential borrower affects the cost of debt, the borrowers’ incentive to take on risky projects, and the stability of lending relationships over time.

Excessive risk-taking is a first-order consideration in the context of debt contracting. Debt financing induces borrowers to take on risky projects, especially if the firm’s current economic condition is weak. This is known as the risk shifting (or asset substitution) problem.

If the only source of borrower-specific information accessible to the competing lenders is public accounting data, our paper shows that the risk-shifting incentive for weak borrowers will always be exacerbated if accounting information becomes more precise. The argument is straightforward. The more precise the public information, the more transparently the borrower’s (weak) economic condition will be revealed to the potential lenders. Consequently, a new loan will be priced at a high face value, further weakening the borrower’s economic condition. In response, the borrower will take on even riskier projects. Introducing some degree of reporting imprecision (“noise”) to camouflage some weak borrowers as strong, lowers their cost of debt. Weak borrowers thus will choose safer, more efficient projects – and it is those borrowers for whom the risk-shifting problem is most pronounced in the first place.

In practice, banks often lend repeatedly to the same borrower. As a result of past loan monitoring, these banks gain privileged information, which they can use in the pricing of follow-on loans. Such relationship lending has been shown to ease borrowers’ access to financing during economic downturns, but it also gives banks information monopoly power to extract rents from borrowers (Rajan, 1992), which gives rise to a hold-up problem. To avoid lock-in and limit the rent extracted by relationship lenders, borrowers often invite competition among multiple lenders for new loans. Anticipating their information disadvantage, outside lenders will price-protect by bidding more cautiously for the loan terms. As a result, the expected face value of debt goes up, as compared with a setting where all potential lenders have access only to public information. Hence, the borrower again takes on excessive risks. Our paper thus identifies a novel cost of relationship lending: exacerbated risk-shifting by weak borrowers.

Returning to the initial inquiry: how is debt contracting efficiency affected by the precision of public accounting information when differentially informed lenders compete to extend loans? Publicly available accounting information levels the playing field between “inside” (relationship) lenders and outside lenders. Increasing public information quality would always alleviate the hold-up problem that was at the heart of Rajan (1992). In contrast, we show that if the main concern is risk-shifting on the part of the borrower, then regulations that increase the precision of accounting reports can improve or harm investment efficiency, depending on the beliefs held by the market participants about the borrower’s condition at the outset. In times where these beliefs lean towards pessimism, increasing the precision of accounting information tends to mitigate the risk-shifting problem for weak borrowers, at the margin; optimistic beliefs tend to have the opposite effect. Therefore, from the perspective of debt contracting efficiency, standard setters should consider loosening financial reporting standards in boom times and tightening them during economic downturns when the sentiment about individual firms’ outlook darkens.

Our study also sheds new light on the stability of lending relationships over time. With public accounting information leveling the playing field among potential lenders, one might expect that more public information would foster creditor turnover, by making the outsiders more competitive. This reasoning ignores that outside creditors will price protect to avoid the “winner’s curse” (whereby, conditional on winning the lending auction, an outsider lender is likely to have extended a loan to a bad-credit borrower), as well as the strategic response taken by the insider when bidding for loan terms. We show that more precise accounting information often decreases the incidence of creditor turnover. Put differently, leveling the playing field tends to render lending relationships more stable, somewhat paradoxically. We relate this finding to recent empirical studies that have found evidence consistent with our predictions using data on platforms where lenders share information about borrowers.

In summary, our paper contributes to the understanding of lending in the presence of information frictions. We identify a novel cost of relationship lending – exacerbated risk shifting by weak borrowers – and show that leveling the playing field among differentially informed creditors, by way of improving accounting quality, may have unexpected consequences for the stability of lending relationships. The paper contains an extensive discussion of the empirical implications of our findings.