Borrowers' Financial Reporting and the Quality of Banks' Loan Portfolios

ABSTRACT I examine the relation between borrowers' financial reporting (FR) and the quality of banks' loan portfolios. This relation is theoretically ambiguous as better FR not only improves banks' monitoring of loans, but also grants more creditworthy borrowers cheaper access to alternative public funding, increasing competition and creating adverse selection problems for banks. Using the adoption of Sarbanes-Oxley Act Section 404 to identify improvements in borrowers' FR, I find an overall positive effect of FR on banks' lending: the quality of loans extended to borrowers subject to Section 404 improves relative to the quality of loans extended by the same bank to other borrowers exempted from Section 404. Additional tests examining borrowers' internal control over FR and loan contracts' characteristics confirm that improved monitoring and screening are both responsible for the higher loan portfolio quality. Overall, my study highlights unexplored consequences of companies' FR on the quality of banks' assets. Data Availability: Untabulated results and analyses mentioned in the article are available as an Online Appendix, see the link in Appendix E. JEL Classifications: D82; G14; G21; M41; M42.