Andrew Sutherland

Financial Statements as Monitoring Mechanisms: Evidence from Small Commercial Loans

Using a dataset which records banks’ ongoing requests of information from small commercial borrowers, we examine when banks use financial statements to monitor borrowers after loan origination. We find banks request financial statements for half the loans and this variation is related to borrower credit risk, relationship length, collateral, and the provision of business tax returns, but in complex ways. The relation between borrower risk and financial statement requests has an inverted U-shape; and tax returns can be both substitutes and complements to financial statements, conditional on borrower characteristics and the degree of bank-borrower information asymmetry. Frequent financial reporting is used to monitor collateral, but only for non-real estate loans and only when the collateral is easily accessible to lenders. Collectively, our results provide novel evidence of a fundamental information demand for financial reporting in monitoring small commercial borrowers and a specific channel through which banks fulfill their role as delegated monitors.

Commercial Lending Concentration and Bank Expertise: Evidence from Borrower Financial Statements

Lending concentration features prominently in models of information acquisition by banks, but empirical evidence on its role is limited. Using bank-level loan exposures, we find banks are less likely to collect audited financial statements from firms in industries and regions in which they have more exposure. These findings are stronger in settings in which adverse selection is acute and muted when the bank lacks experience with an exposure. Our results offer novel evidence on how bank characteristics are related to the type of financial information they use and support theoretical predictions suggesting portfolio concentration reveals a banks relative expertise.

Economic Growth and Financial Statement Verification

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 at nearly twice the rate of firms in other industries during the housing boom period before 2008. This reduction was most severe in the regions that experienced the most significant construction loan growth. 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 reveal that macroeconomic credit fluctuations produce temporal shifts in the overall level of financial statement verification in the economy and that temporal shifts in verification are related to bank loan portfolio quality and borrower performance.

Economic Growth and Financial Statement Verification: ECONOMIC GROWTH AND FINANCIAL STATEMENT VERIFICATION

We use a proprietary dataset of financial statements collected by banks to examine whether economic growth is related to the use of financial statement verification in debt financing. Exploiting the distinct economic growth and contraction patterns of the construction industry over the years 2002 to 2011, our estimates reveal that banks reduced their collection of unqualified audited financial statements from construction firms at nearly twice the rate of firms in other industries during the housing boom period before 2008. This reduction was most severe in the regions that experienced the most significant construction growth. These trends reversed during the sub-sequent housing crisis in 2008 to 2011 when construction activity contracted. Moreover, using bank- and firm-level data we find a strong negative (positive) relation between audited financial statements during the growth period and subsequent loan losses (construction firm survival) during the contraction period. Collectively, our results reveal that macroeconomic fluctuations pro-duce temporal shifts in the overall level of financial statement verification and that temporal shifts in verification are related to bank loan portfolio quality and borrower performance.

Economics of Voluntary Information Sharing

We show that lenders join a U.S. commercial credit bureau when information asymmetries between incumbents and entrants create an adverse selection problem that hinders market entry. Lenders also delay joining when information asymmetries protect them from competition in existing markets, consistent with lenders trading off new market entry against heightened competition. We exploit shocks to information coverage to show that lenders enter new markets after joining the bureau in a pattern consistent with this trade-off. Our results illuminate why intermediaries voluntarily share information and show how financial technology that mitigates information asymmetries can shape the boundaries of lending.

Institutional Investor Attention and Firm Disclosure

We study how short-term changes in institutional owner attention affect managers’ short-term disclosure choices. Holding institutional ownership constant and controlling for industry-quarter effects, we find that managers respond to attention by increasing the number of forecasts and 8-K filings. Rather than alter the decision of whether to forecast or to provide more informative disclosures, attention causes minor disclosure adjustments. Although attention explains significant variation in the quantity of disclosure, we find little change in abnormal volume and volatility, the bid-ask spread, or depth. Overall, our evidence suggests that management responds to temporary institutional investor attention by making disclosures that have little effect on information quality or liquidity.We study how exogenous short-term changes in institutional owner attention affect managers’ short-term disclosure choices. Holding institutional ownership constant and controlling for industry-quarter effects, we find that managers respond to attention by increasing the number of forecasts and 8-K filings. Rather than alter the decision of whether to forecast or to provide more informative disclosures, attention causes minor disclosure adjustments. Although attention explains significant variation in the quantity of disclosure, we find no change in forecast properties, abnormal volume and volatility, the bid-ask spread, or price impact of trades. Overall, our evidence suggests that management placates temporary institutional investor attention by making disclosures that have little effect on information quality or liquidity.

Regulatory Spillovers in Common Audit Markets

We find that Sarbanes-Oxley (SOX) had two significant effects on the audit market for nonpublic entities. The first short-run effect stems from inelastic labor supply coupled with an audit demand shock from public companies. As a result, private companies reduced their use of attested financial reports in bank financing by 12%, and audit fee increases for nonprofit organizations (NPOs) more than doubled. The second long-run effect was a transformation in the audit supply structure. After SOX, NPOs were less likely to match with auditors most exposed to public companies, while auditors increasingly specialized their offices based on client type. Audit market concentration for NPOs dropped by more than half within five years of SOX and remained at this level through the end of our sample in 2013, while the number of suppliers increased by 26%. Our results demonstrate how regulation directed at public companies generates economically im-portant spillovers for nonpublic entities.