DOI: 10.1111/1475-679X.12048Journal of Accounting Research

Vol. 52 No. 2 May 2014Printed in U.S.A.

Identifying Disclosure Incentivesof Bank Borrowers

During a Banking Crisis

J A N N I S B I S C H O F∗

1. Introduction

A lender’s acquisition of private information about its borrowers is a fun-damental characteristic of relationship banking (Leland and Pyle [1977],Diamond [1984]). Relationship lending provides borrowers with an oppor-tunity to avoid the public disclosure of private information and, instead,to disclose only to a small number of private lenders, reducing the propri-etary costs of public disclosure. While borrowers benefit from the lenders’informational advantage through lower borrowing costs (e.g., Berger andUdell [1995]), the information asymmetry also hinders the borrowers’ability to attract funding from alternative financing sources and, thus, helpsexplain the stickiness of lending relationships. Borrowers will trade off thenet costs of public disclosure, that is, the costs from mitigating the lender’sinformational advantage, against the costs from being locked in a relation-ship with the borrower. The information asymmetry becomes particularlycostly for the borrower in the event that the lender experiences a shockto its capability to provide sufficient financing in the future. Lo [2014]argues that the more constrained a bank’s lending capacity becomes, themore a borrower benefits from having access to external funding sources(see also Becker and Ivashina [2014]), explaining the incentive to mitigatethe information asymmetry through voluntary disclosure. The study usesthe emerging-market crisis of U.S. banks in the late 1990s to test thishypothesis.

∗University of Mannheim.Accepted by Douglas Skinner. I wish to thank Ray Ball, Holger Daske, Brandon Gipper,

and Alvis Lo for helpful comments. I wrote the discussion while visiting Chicago Booth Schoolof Business and gratefully acknowledge the financial support from the German AcademicExchange Service (DAAD Postdoc Program).

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Copyright C©, University of Chicago on behalf of the Accounting Research Center, 2014

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Lo [2014] finds that U.S. borrowers from banks that had direct ex-posure to emerging markets in Asia, Russia, and Latin America hadan increased management forecast propensity during the crisis com-pared to other U.S. borrowers. Consistent with the borrowers’ in-creased disclosure being induced by the economic shock to the lender,the observed increase in the management forecast propensity is pos-itively associated with the lender’s exposure to emerging market riskand the borrowers’ risk of being affected by the lender’s credit ra-tioning. In robustness tests, alternative proxies for voluntary disclosure(forecast informativeness, frequency of conference calls, length of theManagement Discussion and Analysis (MD&A) section) yield similarresults.

Lo [2014] contributes to the literature by studying the heterogeneous re-porting incentives of bank borrowers that arise from relationship lending.He documents that the borrowers’ reporting incentives are not low per sebut are low only when the risk of a lending constraint is low. This is an im-portant finding that contributes to the literature on disclosure incentivesin debt markets (Bharath, Sunder, and Sunder [2008], Dhaliwal, Khurana,and Pereira [2011]) and, more fundamentally, on the role of informationasymmetry in relationship lending (see Boot [2000] for a review). Lo imple-ments a careful identification strategy and conducts a battery of differentrobustness tests to fortify his results. Two main issues complicate the iden-tification. First, the banking literature provides evidence that lenders andborrowers select each other (e.g., Berger and Udell [1995], Berger et al.[2005]), thus creating a potential self-selection problem if borrowers of af-fected banks have any unique characteristics. Second, the time window thatis necessary to observe borrowers’ disclosure changes is relatively long, thusincreasing the likelihood of borrowers being affected by simultaneous realeffects.

In the first part of my discussion, I elaborate on the plausibility of thesecompeting explanations in the context of Lo’s research design and the re-sults of the robustness tests. Lo [2014] addresses the first concern aboutexposed banks’ borrowers being themselves exposed to emerging marketsin different ways. The most convincing argument is most likely the ob-servation that the increased forecast propensity of exposed banks’ bor-rowers is not attributable to an increase in bad news forecasts (relativeto other borrowers). The second concern remains more severe. Prior lit-erature attributes adverse changes in real activities of borrowers of ex-posed banks during the emerging market crisis to these banks’ financingconstraints (Chava and Purnanandam [2011]). In a time window as longas two years, it is difficult to disentangle the direct effect of the changein bank health on borrowers’ disclosures (i.e., a borrower’s anticipationof future lending constraints) from indirect effects through the changein a borrower’s real activities. While the second concern does not miti-gate the contribution of Lo [2014], it does highlight that the economic

IDENTIFYING DISCLOSURE INCENTIVES OF BANK BORROWERS 585

mechanism behind the observed disclosure change remains, at least par-tially, unresolved.

In the second part of my discussion, I argue that, given the length ofthe event window, it is useful to explore intertemporal variation in bor-rowers’ disclosure changes. Specifically, I suggest that heterogeneity in thedisclosures of borrowers’ main banks can be used to explain this variation.To maintain the benefits from relationship lending, banks have an incen-tive not to disclose information that could cause borrowers to reduce thelender’s information advantage and resort to alternative financing sources.Thus, bank disclosures are likely to introduce variation in the timing atwhich different borrowers learned about their main bank’s financial diffi-culties. I study the risk disclosure practice (i.e., the country-level risk expo-sures) of the 14 exposed banks in Lo’s sample in more detail. My findingsshow that there is at least some variation in the time at which (1) lenderswere materially affected by the crisis, and (2) they publicly released theirexposure. I use the variation to illustrate corresponding patterns in the tim-ing of borrowers’ disclosure changes. My results are largely consistent withthe mechanism described in Lo [2014]; they additionally emphasize theimportance of the lending bank’s transparency in the borrower’s decisionto expand voluntary disclosures.

2. Relationship Lending and Borrowers’ Transparency

2.1 EMPIRICAL CHALLENGE

Lo’s basic premise is that borrowers change their disclosure behavior indirect response to the financial health of their relationship lender. An em-pirical test of this hypothesis is challenging because economic shocks withinan economy typically hit lenders and borrowers simultaneously. Therefore,it is usually difficult to disentangle increased disclosures that address theimmediate impact of a crisis on a borrower from those disclosures that arein response to the lender’s constraints (i.e., independent of the borrower’sown financial situation). Lo [2014] argues that the emerging-market crisisin the late 1990s provides a setting where an economic shock distresseslenders while leaving borrowers largely unaffected. Moreover, evidencefrom the crisis suggests that the economic shock from exposure to emerg-ing markets affects different lenders to a different extent (Kho, Lee, andStulz [2000]). Lo exploits the variation in lenders’ exposure to implementa difference-in-differences design. Specifically, he tests whether the changein the disclosures of exposed banks’ borrowers during the crisis significantlydiffers from the change in the disclosures of unaffected banks’ borrowers.

The test relies on the assumption that the banking shock hits bor-rowers randomly, that is, that being a borrower of an affected bank isnot correlated with other factors that could explain disclosure changesaround the time of the banking shock. If it was true that borrowers and

586 J. BISCHOF

lenders randomly select each other, differences in the change in disclosurebehavior between the borrowers of the two types of banks would be directlyattributable to the change in bank health. Two issues seem to be partic-ularly critical for maintaining this assumption. First, prior literature indi-cates that a bank’s portfolio of loans, and thus the choice of its borrowers,is associated with bank characteristics, such as size, branch network, andgeographic location (e.g., Berger et al. [2005]). Banks that were affectedby the crisis could thus have a distinct group of borrowers. Second, thelength of the time window complicates the identification. The time windowthat is used for identification covers two years. This is a major differencefrom other studies on the consequences of lending constraints during the1997–1998 banking crisis, mainly from the finance literature (e.g., Chavaand Purnanandam [2011] use a 20-day time window around the Russiancrisis in 1998 to identify borrowers’ valuation losses in response to lend-ing constraints). The longer time span in Lo [2014] is necessary to capturechanges in disclosure that, by their very nature, rarely occur within a fewdays or even a month (unlike, for example, stock prices). However, thelength increases the likelihood of real effects of the lending constraints or,more generally, other simultaneous trends influencing disclosure behaviorand, thus, makes it difficult to disentangle the different explanations for adisclosure change.

2.2 IDENTIFICATION STRATEGY AND ALTERNATIVE EXPLANATIONS

Lo [2014] applies firm-fixed effects in the difference-in-differences de-sign of the main analysis and a large number of robustness tests in addi-tional analyses to address the empirical challenge of the research setting.The design is able to rule out alternative explanations that rely on sys-tematic, but time-invariant, differences between the borrowers of affectedand unaffected banks. For example, the cross-sectional analysis of affectedbanks’ borrowers (equation 3) suggests that the likelihood of increased vol-untary disclosure is positively associated with the borrower’s investment inintangible assets and research and development (R&D) activities. Thus, in-creased disclosures could be largely concentrated among high-growth in-ternet firms that were considerably investing in growth at this time. Thecoincidence of the emerging market crisis with the large growth of inter-net firms in the late 1990s is still unlikely to bias the findings in the mainanalysis (equation 1). The coefficient estimates from equation (1) wouldonly be biased if affected banks were more likely to select borrowers fromthe internet industry. However, there is no reason to expect that the expo-sure to emerging markets is associated with credit risk concentration in theinternet industry.

Any alternative explanation that plausibly biases the main test in Lo[2014] must relate to changes in unique characteristics of affected banks’borrowers that coincide with the emerging market crisis. To find such anexplanation, it is important to consider whether exposure to the emerg-ing market crisis reflects a bank’s choice of a specific business model that

IDENTIFYING DISCLOSURE INCENTIVES OF BANK BORROWERS 587

is likely to be associated with the characteristics of the bank’s borrowers.One alternative explanation that meets this condition is the greater like-lihood of exposed banks’ borrowers being directly affected by the crisis.Firms that invest in emerging markets, or maintain business relations withsuppliers and customers from these markets, will benefit from contractingwith lenders that have expertise and local presence in the specific region(i.e., the exposed banks). Consistent with the findings in Berger and Udell[1995], the exposed banks are able to use their expertise in the screeningand monitoring of borrowers and, thus, possess superior private informa-tion which, on average, manifests in lower borrowing costs. In short, beinga borrower of an exposed bank possibly proxies for greater direct exposureto emerging markets.

The crisis induces higher uncertainty about the future prospects of theseborrowers and, thus, increases demand for forward-looking information(as reflected in management forecasts and conference calls). The mutualexposure of lenders and borrowers to emerging markets is particularlycrucial because the emerging market shock did produce bad news forborrowers (i.e., negative forecasts). The increased disclosure during thecrisis is then a response to the change in the firms’ economic conditionrather than the financial health of the relationship lender. While thischaracteristic of exposed banks’ borrowers is time-invariant, it is importantto note that the firm-fixed effects still do not sufficiently control for thealternative explanation because the banking crisis coincides with the directimpact of the crisis on borrowers’ activities in the region.

The descriptive statistics in table 2, panel B, in Lo [2014] provide mixedevidence on the credibility of the alternative explanation. On the one hand,cash flow volatility increases more for borrowers of exposed banks thanfor other borrowers during the crisis (weakly significant), although withoutknowledge about changes in the absolute level of operating cash flows, itis unclear how to interpret this difference. Other potential indicators offinancial troubles (return on assets, loss indicator, and abnormal return)do not reveal statistically significant differences between the two groups ofborrowers.

Two robustness tests in Lo [2014] also address the concern. First, Lo ex-amines borrowers’ geographic segment disclosures (see section 3.1 and theonline appendix).1 The evidence suggests that the results are unaffectedwhen excluding all borrowers that disclose sales revenues from foreign mar-kets in the segment report. However, the information content of the seg-ment disclosures is limited. Emerging market activities are not confined tosales revenues. Direct investments or relationships with suppliers that arenot included in the segment report could pose similar risks. Moreover, for-eign sales revenues from emerging markets are aggregated and combined

1 An online appendix to Lo [2014] can be downloaded at http://research.chicagobooth.edu/arc/journal/onlineappendices.aspx.

588 J. BISCHOF

with revenues from other foreign markets not affected by the crisis. Whilethe evidence suggests that aggregate foreign sales revenues are similar forboth groups of borrowers, concerns about substantial differences in the ge-ographical composition of these foreign sales revenues remain. In fact, bor-rowers of exposed banks should have an incentive to voluntarily disclose thecomposition of their foreign sales revenues if these revenues were mainlyfrom unaffected countries, that is, if the disclosure would reveal good news.

Second, the assessment of changes in the composition of the forecastssuggests that the voluntary disclosure of both bad news and good news in-creases around the emerging market crisis (footnote 29). This test is bet-ter able to mitigate the concerns about the self-selection of borrowers. Ifborrowers’ direct exposure to the crisis caused the disclosure change, thedirect exposure to the crisis would have, most likely, given rise to a dispro-portionate increase in forecasts revealing bad news (at least, if litigation riskwas the main driver of the disclosure change).

2.3 DIRECT VERSUS INDIRECT EFFECTS OF THE BANKING SHOCK

Even if we disregard the borrowers’ potential exposure to emerging mar-kets, the incentive for the disclosure change after the banking shock re-mains an open question. As suggested by Lo [2014], the results of the maintest can be explained by firms expanding voluntary disclosures in antici-pation of potential lending constraints and to attract alternative financierson public debt markets, that is, in direct response to the banking shock. Al-ternatively, voluntary disclosure could also be a second-order effect of thebanking shock, that is, a response to other economic changes that arisefrom the banking shock.

The additional tests in Lo [2014], table 4, columns (3)–(6), that exploitcross-sectional variation in firm characteristics within the group of affectedborrowers emphasize this issue. The firm characteristics (tangibility of as-sets, R&D activities, leverage, and a default risk score) are reasonable prox-ies for borrowers’ credit risk. The idea is that banks are more likely toreduce lending to risky borrowers during a crisis. As a result, credit riskshould be positively associated with the borrowers’ disclosure change if thedisclosure change is causally related to bank health. From this perspective,the tests are convincing in attributing the increased disclosures to antici-pated loan tightening of exposed banks (i.e., consistent with the direct ef-fect). However, the riskiest borrowers are also least likely to ever access thepublic debt market (Denis and Mihov [2003]). In fact, there exist a num-ber of alternative, potentially more suitable, financing sources available toconstrained borrowers. Thus, if the riskiest borrowers turn to other privatelenders (e.g., other arrangers in the syndication process) as opposed to en-tering the public debt market, it is less plausible that the purpose of thedisclosure change is to attract external financing.

The above ambiguous predictions still beg the question of where the in-direct effect could come from. The potential need for external financing isnot the only impact that a deterioration of a lender’s financial situation has

IDENTIFYING DISCLOSURE INCENTIVES OF BANK BORROWERS 589

on a borrower. Lending constraints, through a change in borrowers’ capitalexpenditures, cause a reduction in borrowers’ profitability and, almost im-mediately, significant valuation losses (Chava and Purnanandam [2011]).As Lo [2014] acknowledges, the real frictions trigger increased demand formore disclosure by current investors and, thus, provide reporting incentivesof their own. The coincidence of the real frictions and the borrowers’ re-financing needs poses a challenge in identifying the economic mechanismof how bank health relates to borrowers’ disclosure.

Particularly, the length of the time window of the treatment effect be-comes critical. Over a period of two years, it is plausible that firms expe-rience real effects from the lenders’ financing constraints and are able toactually react to these frictions (prior evidence from the emerging marketcrisis actually suggests that, in the longer term, affected borrowers, unlikeunaffected borrowers, encounter severe economic difficulties; Chava andPurnanandam [2011]). Thus, it is critical for the research design to sepa-rate those borrowers that are trying to mitigate information asymmetriesbetween the relationship lender and potential public lenders from borrow-ers that simply address the real effects of the lending constraints, such asthe reduction of capital expenditures, in the expanded disclosures, leav-ing the disclosure expansion only indirectly related to the banking shock.Because evidence surrounding borrowers’ actual financing constraints andfinancing policies after the disclosure change is missing in this analysis, Icaution that the economic mechanism that explains the association of bankborrowers’ disclosure behavior with bank health remains a question openfor further debate.

The discussion about the link between bank health and borrowers’ dis-closure is important to understand the paper’s contribution and to put theresults into the context of previous research. Lo [2014] documents thatthe stability of a borrower’s banking relationship sets reporting incentivesand that the transparency of a borrower, thus, varies over time with thefinancial health of the relationship lender. This finding is an importantand significant contribution. However, the link to the accounting litera-ture in part depends on the economic mechanism behind the association.For example, previous research has established that, on average, financingthrough private loans is associated with lower transparency than financingthrough public debt (e.g., Bharath, Sunder, and Sunder [2008], Dhaliwal,Khurana, and Pereira [2011], Haw, Lee, and Lee [2014]). If borrowers ac-tually changed their disclosure behavior in response to real changes in theirfinancing choice, and the disclosure changes are only indirectly related tothe relationship lender’s financial health, the evidence would largely re-semble this part of the literature, adding another dimension of disclosurequality (management forecast propensity) and a new setting.

As outlined above, and as acknowledged in Lo [2014], the setting andthe sticky nature of firm disclosures are not suitable for distinguishing be-tween potential direct and indirect mechanisms. Regardless of the mech-anism, however, the initial event is an adverse change in the relationship

590 J. BISCHOF

lenders’ health. Therefore, it seems helpful to view the paper in light ofthe literature on relationship banking. The information asymmetry be-tween the relationship lender and potential outside lenders is essential forrelationship banking to exist. There is ample evidence that the existence ofinformation asymmetry is beneficial for both the lender (e.g., Bharath et al.[2007]) and the borrower (e.g., Berger and Udell [1995], Dahiya, Puri, andSaunders [2003]). The fact that borrowers voluntarily mitigate the infor-mation asymmetry through increased disclosures when they expect the re-lationship with the lender to become fragile suggests that the potential costof the fragility of the relationship must be economically substantial. Theliterature on relationship banking has discussed several ways for borrowersto overcome this dependency in times of crisis (see, for example, the sum-mary in Boot [2000]). Lo’s results suggest that disclosure expansion is oneof these alternatives.

Thus, the reporting incentives that arise from relationship lending alsorelate to the extensive literature on the economic consequences of thebonding between lender and borrower. We know little about how disclo-sure can, on both sides of the relationship, mitigate potentially harmfuleffects of the mutual dependency. Lo [2014] addresses this question by pro-viding evidence of borrowers’ disclosure behavior. However, just as borrow-ers rationally form expectations about future costs and benefits from theirrelationships with lenders, lenders also anticipate that voluntary disclosurewill increase the likelihood of borrowers choosing to borrow from a com-petitor and, thus, increase the risk of losing the net benefits of their in-formational advantage. This is one of the reasons why financial firms haveincentives not to disclose bad news, such as risk exposures, during a crisis.I focus more on this question in the next section.

3. Staggered Changes in Borrowers’ Perception of Bank HealthDuring the Crisis

3.1 POTENTIAL CONTRIBUTION OF INTERTEMPORAL VARIATION TOIDENTIFICATION

Lo [2014] exploits substantial cross-sectional variation in borrowers’characteristics for his identification. As discussed in section 2, one majorissue in his research setting is the length of the crisis event that he needsto capture borrowers’ disclosure changes. The indicator variable for thecrisis period in equation (1) captures eight subsequent quarters from 1997-Q3 to 1999-Q2. Thus, the observed coefficient could come from differentpatterns in the timing of borrowers’ disclosure changes. A lengthy time win-dow of a treatment could offer additional opportunities for identificationif the variation of responses to the treatment over time can be meaning-fully linked to treatment characteristics. One example is the literature onregulation effects that exploits staggered implementation of the regulationacross different subsets of firms (e.g., Christensen, Hail, and Leuz [2013]).

IDENTIFYING DISCLOSURE INCENTIVES OF BANK BORROWERS 591

The fact that Lo studies the banking sector could produce this typeof variation. The composition of a bank’s loan portfolio is proprietaryinformation and is thus especially costly to disclose (Diamond [1984]).Consistent with this idea, prior evidence suggests that banks’ risk exposureis, at least to some extent, relatively opaque during a financial crisis (e.g.,Morgan [2002], Iannotta [2006], Ryan [2008], Barth and Landsman[2010], Bischof and Daske [2013], Flannery, Kwan, and Nimalendran[2013]). In this section, I will link Lo’s research design to this literatureby studying how banks communicated their exposure to emerging marketsin the late 1990s and to what extent the variation in these disclosures ex-plains the intertemporal variation in borrowers’ disclosure changes duringthe crisis period.

3.2 BANKS’ RISK DISCLOSURES DURING THE EMERGING MARKET CRISIS

Lo [2014] uses two sources to identify banks’ exposures. First, he relieson the classification by Kho, Lee, and Stulz [2000] that uses informationfrom banks’ annual reports. The annual report disclosures mainly followthe requirements in SEC Industry Guide 3. The industry guide requiresbank-holding companies to state the aggregate amount of cross-border out-standings to borrowers in each foreign country where the outstandingsexceed 1% of the bank-holding company’s total assets (section III.C.3.).The 1% threshold is substantive given that the minimum capital thresholdis 4% of risk-weighted assets (i.e., because risk-weighted assets are on av-erage substantially lower than total assets, a bank would not be requiredto disclose cross-border outstandings to one individual country even if itaccounts for more than 25% of its core capital). As a result, the thresh-old leaves substantial room for discretion in banks’ voluntary disclosures ofemerging market exposures.

Second, Lo [2014] uses aggregate information that is provided by theFederal Financial Institutions Examination Council (FFIEC). Banks peri-odically submit detailed information about their cross-border outstandingsto the FFIEC (Form 009). Unlike other regulatory filings (e.g., the FR Y-9Creports), however, these country exposure reports are not publicly acces-sible. The FFIEC discloses aggregate information for different groups ofbanks. These aggregate reports are the basis for Lo’s distinction betweenlarge money center banks with high exposures and smaller banks with lowexposures (Lo [2014], table 4). The existence of these filings highlightsthat banks had internal information about cross-border outstandings belowthe 1% threshold and, again, could decide whether to voluntarily includethis information in the annual report.

Table 1 summarizes hand-collected data on the actual disclosures of the14 exposed banks in the 1997 and 1998 10-K and 10-Q reports. The sum-mary statistics show that all banks provided specific information about theirexposure to emerging markets. However, there is variation in the initial tim-ing of the disclosures. While 11 banks were already providing disclosureswhen the crisis started in July 1997, 3 banks (1st Tennessee National, Fleet

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IDENTIFYING DISCLOSURE INCENTIVES OF BANK BORROWERS 593

Financial, Wachovia) did not release country-specific information beforethe issuance of their 1997 annual report in the first quarter of 1998. Thedisclosures reveal that all three banks had very limited exposure to emerg-ing markets. The statistics also show that 10 banks disclosed at least someof the country exposures voluntarily (i.e., the exposure was lower than 1%of the total assets).

Table 1 further documents that the size of banks’ emerging mar-ket exposures is not necessarily captured by the aggregate FFIEC re-port. The five large money center banks according to Lo’s classification(BankAmerica, Chase Manhattan, Citicorp, First Chicago NBD, J.P. Mor-gan) plus Bankers Trust and Bank of New York all had significant expo-sure to Asian economies, that is, were affected by the crisis early in July1997. However, there are also a number of banks that Lo [2014] classifiesas having low exposure, which actually have insignificant exposure to Asianeconomies, but have more substantial exposure to Latin America, that is,were affected by the crisis later in the second half of 1998. These firmsare BankBoston, Comerica, Cullen/Frost Bankers, Fleet Financial, Repub-lic New York, and Wachovia.

To examine whether borrowers relied on the bank-specific information(as included in the financial reports), I exploit the variation in the timingand the content of the bank disclosures. Specifically, I discuss whether thetiming of borrowers’ disclosure changes follows the timing of banks’ initialvoluntary disclosures and the timing of the different crisis events that thebanks were exposed to heterogeneously.

3.3 TIMING OF BORROWERS’ DISCLOSURE CHANGES

For the illustration in this section, I use Lo’s panel data on voluntary man-agement forecasts of borrowers from banks that are exposed to emergingmarket risk (i.e., the same data used in Lo [2014], table 4).2 The sampleincludes 8,258 firm-quarter observations for the time period from 1995-Q3through 1999-Q2. I examine whether there are differences in the time pe-riods in which borrowers increased their voluntary disclosure and whetherthese differences are related to (1) the content, and (2) the timing ofbanks’ risk disclosures.

To this end, I exploit the two differences within the group of exposedbanks that I highlighted in my earlier analysis of banks’ risk disclosures(section 3.2., above). First, banks differ in their exposure to Asian emergingeconomies (that became affected in July 1997) and their exposure to LatinAmerican emerging economies (that became affected in January 1999).Second, banks differ in the timing of their initial voluntary disclosure ofthe exposure to emerging economies. If bank disclosures play a role inthe economy-wide perception of bank health, and if Lo’s idea that bor-rowers’ voluntary disclosures are a function of bank health holds, I should

2 I am grateful to Alvis Lo for generously sharing his data with me.

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FIG. 1.—Variation in the timing of borrowers’ disclosure changes and bank exposure. Thefigure uses firm-quarter data from table 4 of Lo [2014] for the period from 1995-Q3 through1999-Q2 and reports the forecast propensity of borrowers (number of observations for firmsthat issue a management forecast divided by the total number of firm observations). In accor-dance with Lo [2014], Pre-Crisis is the period from 1995-Q3 through 1997-Q2. Post-Asia Crisisrepresents the period from 1997-Q3 through 1998-Q4. Post-Latin America Crisis represents theperiod from 1999-Q1 through 1999-Q2. Exposure to Asia includes borrowers from a main bankthat has larger exposure to Asia than to Latin America. Exposure to Latin America includes bor-rowers from a main bank that has larger exposure to Latin America than to Asia.

observe that (1) borrowers of banks more severely affected by the Asiancrisis increase their voluntary disclosures earlier than borrowers of banksmore severely affected by the Latin American crisis, and that (2) borrowersof banks that provide disclosures of emerging market exposures earlier in-crease their voluntary disclosures earlier.

Figure 1 separately presents the management forecast propensity (calcu-lated as the number of observations of firms that issue a management fore-cast divided by the total number of observations) of borrowers from bankswith larger exposure to Asia and borrowers from banks with larger expo-sure to Latin America over the three relevant time periods. The Exposureto Asia group includes BankBoston, Comerica, Cullen/Frost Bankers, FleetFinancial, Republic New York, and Wachovia. Pre-Crisis represents the pe-riod from 1995-Q3 through 1997-Q2, that is, directly before the outbreakof the crisis in Asia. Post-Asia Crisis represents the period from 1997-Q3through 1998-Q4, that is, when banks were affected by the Asian Crisis butnot yet by the Latin American crisis. Post-Latin America Crisis represents theperiod from 1999-Q1 through 1999-Q2, that is, when banks were also af-fected by the Latin American crisis.

Both groups of borrowers had a similar forecast propensity in the pre-crisis period (19.6% vs. 19.2%). Consistent with borrowers’ disclosure

IDENTIFYING DISCLOSURE INCENTIVES OF BANK BORROWERS 595

FIG. 2.—Variation in the timing of borrowers’ disclosure changes and bank disclosure. Thefigure uses firm-quarter data from table 4 of Lo [2014] for the period from 1995-Q3 through1999-Q2 and reports the forecast propensity of borrowers (number of observations for firmsthat issue a management forecast divided by the total number of firm observations). In ac-cordance with Lo [2014], Pre-Crisis is the period from 1995-Q3 through 1997-Q2. Post-EarlyDisclosure represents the period from 1997-Q3 through 1998-Q1. Post-Late Disclosure representsthe period from 1998-Q2 through 1999-Q2. Early Disclosure includes borrowers from a mainbank that initially disclosed its emerging market exposure as early as 1997-Q3. Late Disclosureincludes borrowers from a main bank that initially disclosed its emerging market exposure in1998-Q1.

changes following bank disclosures, figure 1 illustrates that the forecastpropensity of borrowers from banks with larger exposure to Asia startedto increase considerably in the early period of the crisis (from 19.6% to26.0%). In contrast, I observe the greatest increase in the forecast propen-sity of borrowers from banks with larger exposure to Latin America in thelater period of the crisis, that is, not before the crisis in Latin America be-gan (from 21.4% in the Post-Asia Crisis period to 28.2%).

Figure 2 separately presents the management forecast propensity ofborrowers from banks that started to disclose emerging market exposureearlier during the crisis (i.e., beginning in the 10-Q report for 1997-Q3or earlier) and borrowers from banks that started to disclose later. TheLate Disclosure group includes 1st Tennessee National, Fleet Financial, andWachovia. Pre-Crisis represents again the period from 1995-Q3 through1997-Q2, that is, directly before the outbreak of the crisis in Asia. Post-EarlyDisclosure represents the period from 1997-Q3 through 1998-Q1, that is, be-fore Late Disclosure banks initiated their disclosures. Post-Late Disclosure rep-resents the period from 1998-Q2 through 1999-Q2, that is, when all affectedbanks provided risk disclosures of their emerging market exposures.

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The forecast propensity of both groups was relatively similar before thecrisis (19.7% vs. 18.2%). In the Post-Early Disclosure period, however, I onlyobserve an increase in the forecast propensity of borrowers from banks thathad already initiated their disclosures of emerging market exposures (from19.7% to 23.9%). In the Post-Late Disclosure period, I observe a similar in-crease for the other borrowers. The evidence suggests that borrowers ofbanks that disclosed earlier were more likely to increase their voluntary dis-closure earlier than borrowers of banks that disclosed later, which is againconsistent with borrowers’ disclosure changes following bank disclosures.

Taken together, the evidence indicates that there is at least some het-erogeneity in the timing of changes in borrowers’ disclosure. The evidencesuggests that the pattern of borrowers’ disclosure changes follows heteroge-neous patterns in banks’ risk disclosures. Thus, the evidence is consistentwith bank disclosure shaping borrowers’ assessment of bank health. Theevidence also corroborates Lo’s general finding that, in relationship lend-ing, borrowers’ disclosure behavior is a function of borrowers’ perceptionof the financial health of their relationship bank and, thus, contributes tohis identification strategy.

4. Conclusions

The information asymmetry between a relationship lender and potentialoutside lenders regarding a borrower’s financial situation creates benefitsfor both the relationship lender and the borrower. Lo [2014] provides ev-idence that borrowers from private lenders do not have low reporting in-centives per se. Rather, the evidence suggests that borrowers mitigate theinformation asymmetry by increasing voluntary disclosures when the bank-ing relationship becomes fragile. This is an important contribution to ourunderstanding of relationship banking and the role of private informationin financial intermediation.

The association between a borrower’s level of voluntary disclosure andthe financial health of the relationship lender is robust to a battery of ro-bustness tests. However, the economic mechanism behind this associationremains unclear. Firms may choose to increase their disclosures in an at-tempt to avoid potential lending constraints by attracting outside funding.The evidence in Lo [2014] is consistent with this idea and plausibly rulesout many alternative explanations. However, we know from prior literaturethat borrowers of those banks that were most heavily exposed to the emerg-ing market crisis in the late 1990s experienced real performance shocksaround the same time (with one possible explanation being that these bor-rowers had direct exposure to emerging markets). The length of the eventwindow during which borrowers were likely to experience real effects fromthe lending constraints and react to the friction in a number of differentways makes it difficult to identify the exact economic mechanism throughwhich bank health affects borrowers’ disclosure behavior in relationshiplending.

IDENTIFYING DISCLOSURE INCENTIVES OF BANK BORROWERS 597

In addition, Lo [2014] sheds light on the economy-wide perception ofbanks’ risk exposures during a crisis. Banks’ risk disclosures during a crisisare widely viewed as opaque. However, the evidence suggests that borrowershad relatively precise knowledge about their lenders’ exposure to emergingmarkets (either through private or public information). I explore banks’risk disclosures around this time and find that banks had at least some dis-cretion in how to present their exposures to emerging markets. I use theresulting variation in the timing and the content of banks’ risk disclosuresto argue that the variation is useful in explaining the pattern of borrowers’disclosure changes in Lo’s research setting. More precisely, borrowers’ dis-closure behavior follows a pattern that is consistent with bank disclosuresshaping borrowers’ perception of bank health. This result also indicatesthat bank disclosures play a role in the dissemination of information aboutrisk exposures.

Information asymmetry about the characteristics of borrowers, whichis inherent to relationship banking, apparently contributes to shapereporting behavior on both sides of the relationship, rendering relation-ship banking an interesting area for accounting research. For example, it isfrequently argued, and also noted by Lo [2014], that differences in firms’reliance on relationship lending help explain cross-country differences inreporting properties (e.g., Ball, Kothari, and Robin [2000], Burgstahler,Hail, and Leuz [2006], Bushman and Piotroski [2006]). However, theprevalence of relationship banking is complementary to other elements ofgovernance and ownership structures within a country (Ball, Kothari, andRobin [2000], Leuz and Wustemann [2004]), with the interaction render-ing the empirical identification of any effect of relationship banking at leastchallenging. The global banking crisis and the recent changes in the bank-ing system of many countries are likely to provide settings in which we canfurther explore the role of lending relationships in borrowers’ and lenders’disclosure behavior.

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