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Loan relation with foreign banks and information asymmetry: evidence from earnings management by local firms in Korea

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Abstract

Previous research shows that foreign (domestic) banks rely more on ‘hard’ (‘soft’) information in their lending decisions and such approaches may give a motivation for the local firms to improve their credit scores by, for example, overstating earnings. The paper develops a theoretical model and empirically tests the model using actual data from Korea. The model predicts that local firms tend to overstate earnings when they increase the loan relations with foreign banks and the proportion of local firms with earnings management increases as the recoverability of foreign banks decreases (increases) in the higher (lower) level of recoverability. The results of the empirical test are consistent with the predictions by the model. We also discuss the implications of the study and an extension for the future study.

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Notes

  1. The change is shown as a movement from point A\( \left(\widehat{x}\left( FN, FE\right)\right) \) to point B\( \left(\widehat{\widehat{x}}\left( FN, FE\right)\right) \) which denotes a new marginal firm indifferent between FN and FE in Figure 1.

  2. It can be considered as the foreign bank sells its loan to the firms without earnings management at a full loan price and a discounted price of \( \left(1-\alpha \right)\beta {\tilde{r}}_F \) to the firms with earnings management.

  3. The change is shown as a movement from point C\( \left(\widehat{x}\left( FE, DN\right)\right) \) to point D\( \left(\widehat{\widehat{x}}\left( FE, DN\right)\right) \) which denotes a new marginal firm indifferent between FE and DN in Figure 1.

  4. The change is shown as a movement from point A\( \left(\widehat{x}\left( FN, FE\right)\right) \) to point B\( \left(\widehat{\widehat{x}}\left( FN, FE\right)\right) \) which denotes a new marginal firm indifferent between FN and FE in Figure 4.

  5. The change is shown as a movement from point C\( \left(\widehat{x}\left( FE, DN\right)\right) \) to point D\( \left(\widehat{\widehat{x}}\left( FE, DN\right)\right) \) which denotes a new marginal firm indifferent between FE and DN in Figure 4.

  6. Korea has adopted IFRS since 2012 and we use firm data before the IFRS adoption for the study.

  7. There has been many studies on the firm-bank relationship in Korea after the Asian financial crisis. For example, Sohn and Choi (2011) have investigated the impact of pre-existing relationship on the lending decisions by Korean banks after merger.

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Acknowledgements

This work was supported by the Ministry of Education of the Republic of Korea and the National Research Foundation of Korea (NRF-2018S1A5A2A01037704).

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Authors and Affiliations

  1. Seoul National University of Science and Technology, 232 Gongneung-ro, Nowon-gu, Seoul, South Korea

    Sangwook Lee

  2. Clark University, 950 Main Street, Worcester, MA, 01610-1477, USA

    Sang Hoo Bae & Inshik Seol

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  1. Sangwook Lee
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Lee, S., Bae, S.H. & Seol, I. Loan relation with foreign banks and information asymmetry: evidence from earnings management by local firms in Korea. J Econ Finan 43, 344–366 (2019). https://doi.org/10.1007/s12197-018-9465-7

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