Bank’s collection of private debtor information

The term “monitoring” is used throughout the text primarily to imply the collection and production of private information regarding borrower’s financial situation to enable a bank to

1023 Fama, Journal of Monetary Economics, 1985, 29, p. 37.

1024 Rajan/Winton, Journal of Finance, 1995, 1113, and Berger/Udell, The Economic Journal, 2002, F32–

F53.

1025 Borrower’s proprietary information implies information that is private to borrowers and inaccessible to the public. This information does not include e.g. firm’s annual accounts or profit and loss statements, which are obtainable by the investing or non-investing public.

1026 Berger/Udell, The Economic Journal, 2002, F32–F53, p. F36.

1027 Cole, Journal of Banking and Finance, 1998, 959; Berger/Udell, Journal of Business, 1995, 351.

react timely and adequately to an impairment of the financial situation of the borrower with the purpose to ensure the repayment of the loan. It was previously explained that banks as financial intermediaries are better placed to collect that information efficiently, reducing in this way information asymmetries. The reduction of information asymmetries allows banks to monitor debtors at lower costs. Monitoring by banks is a two steps process, involving ante and ex-post collection of information, taking as a reference point the moment when the funds could be or have been provided to the borrower by the bank.

1. Collecting information ex-ante: screening

Ex-ante monitoring by bans takes place before the lending contract is agreed to and serves to sort out “bad” debtors¹⁰²⁸ and hence to reduce the proportion of would-be problematic or non-performing loans. This process is known as screening and it involves an information-gathering exercise for the purpose of deciding whether to provide funds for the firm’s investment. ¹⁰²⁹ Because this exercise takes place before the funds are provided, both kinds of borrowers, “good”

and “bad” are subject to it. However, this process is aimed primarily at low performing, poor reputation borrowing firms, which have nothing to lose from defaulting by cheating the bank ex-ante or acting opportunistically ex-post. The monitoring role of banks with regard to these debtors is to sort them out by refusing to lend to them. The ex-ante monitoring in this case includes a bank collecting borrower information that allows her, the bank, to assess the credibility of the borrower and evaluate the probability of default. Pursuant to the intermediation theory described above, banks are able to collect and assess debtor information in a cost-effective way, and therefore qualified to perform the monitoring task.¹⁰³⁰ Despite the fact that freeriding problems are widespread among the various creditors contracting with the same debtor, our prediction is that banks have sufficient incentives to overcome these problems and provide debtor monitoring because of the sizeable piece of debt they hold as well as due to their ability to diversify their investment.¹⁰³¹ Moreover, the role of banks in the screening process is that of a typical gatekeeper in the information chain who filters the information coming, in the particular case, from the borrower to ensure that only potential borrowers meeting certain agreed standards pass the gate to access the required funds and that the funds made available reflect the financial

1028 Hellwig, in: Giovannini/Mayer, Financial Integration, p. 46.

1029 Edwards/Fischer, Banks, p. 37.

1030 See Diamond, Review of Economic Studies, 1984, 393, and Diamond, FRBR Economic Quarterly, 1996, 51.

1031 Diamond, Review of Economic Studies, 1984, 393. See also Hoshi/Kashyap/Scharfstein, National Bureau of Economic Research Working Paper Series, 1993, p. 5.

situation of the borrower. In their capacities as screeners, banks play the role of information as well as reputation intermediaries.

Therefore, assuming, as above that bank monitoring is beneficial to both the bank and the firm, pursuant to the gatekeeping theory elaborated in the previous chapters, banks shall have an interest in protecting their reputation capital which they have built up over the years by investing considerable resources. This shall provide banks with the needed incentives to screen potential borrowers carefully.

2. Collecting information ex-post: monitoring

Bank monitoring ex-post takes place after the lending contract has been agreed to and during the execution of the contract. The purpose of this monitoring is to ensure that the borrower will adhere to the terms of the contract and eventually to punish “bad” behaviour by the debtor¹⁰³² that might lead to a non-fulfilment of the loan terms and endanger the interests of the lender, especially when the debtor takes on more risk than it was previously contracted for. This form of monitoring serves to improve the performance of the debtor by providing incentives for the debtor’s managers to act in the interests of capital savers.¹⁰³³ In this sense, the collection of information by the bank is beneficial in so far as it helps the bank to influence debtor behaviour by exerting indirect control over the actions of the debtor’s managers.¹⁰³⁴

The most difficult question that banks face when monitoring ex-post is whether they should continue to lend to the borrower that faces default risks with the purpose of forestalling default or whether they should terminate the lending relationship to avoid higher costs? In these situations banks face what is known in financial literature as the soft budget constraint problem, which implies a lack of ability on the bank’s side to enforce debt contracts.¹⁰³⁵ In such a situation the lending bank needs to decide which approach is less costly and that will enable her to recover the largest portion of the funds loaned. Letting the borrower go bankrupt carries with it not only reputational effects for the monitoring bank¹⁰³⁶ but also the risk that borrower’s assets will devalue at insolvency and therefore will not suffice to repay the loan. However, providing further funds to the borrower facing default with the hope that it would recover previous loans if the borrower is successful in turning the situation around is also a risky approach. Not only would

1032 Hellwig, in: Giovannini/Mayer, Financial Integration, p. 46.

1033 Ibid., p.46; Edwards/Fischer, Banks, p. 37.

1034 Ibid., p.38. See also Broecker, Econometrica, 1990, 429.

1035 See e.g. Boot, Journal of Financial Intermediation, 2000, 7, p. 16.

1036 Edwards/Fischer, Banks, p. 177.

could this approach create a spiral of forced lending just to recover the previous loan, but it could also create perverse incentives for the borrower not to spend sufficient efforts to prevent a bad business outcome.¹⁰³⁷ If the borrower perceives that renegotiation of the debt contract will take place ex-post with a relative ease because the lending bank would like to avoid bankruptcy, then the borrower might lack the proper incentives to exercise care ex-ante to avoid behaviour that would cause the firm to face financial distress. To avoid the creation of such disincentives, banks make use of their advantages as financial intermediaries and engage in producing borrower information in order to evaluate the future prospects of the debtor firm, namely the probability of borrower’s default and insolvency. This information should help the bank to decide whether to extend further credit to debtor firms facing financial difficulties or allow them to go insolvent.

Chemmanur/Fulghieri argue that banks as long term players are interested in gaining a reputation for financial flexibility, i.e. for making the “right” decision for renegotiating the debt versus liquidation.¹⁰³⁸ The effort to gain this reputation and further to maintain it provides banks with incentives to expend more resources to acquire information about firms in financial distress, and this should enable banks to perform a better monitoring.¹⁰³⁹ It is the reputation not only for the credibility of the information produced but also making the right decision with regard to borrower’s potential financing that makes banks into gatekeepers. It was already noted above that without (good) reputation, the existence of the gatekeepers would be put to question. It is the need to maintain the reputation as credible gatekeepers that should provide banks with the incentives to careful ex-ante as well as ex-post monitoring.