University of Chicago Booth Capital Ideas Magazine: Two New Articles

The Summer 2014 issue of Booth Capital Ideas magazine has two new longer pieces by me. Look for it online or at the Gleacher Center in downtown Chicago.

The first article is entitled, “How can you monitor a borrower without financial statements?” It’s based on research by Chicago Booth Assistant Professor Michael Minnis and Booth PhD candidate Andrew Sutherland.

The researchers find that a bank’s decision about whether to request a borrower’s financial statements depends on five things: the bank-borrower relationship, the loan’s credit spread (the difference between the interest rate on the loan and the prime rate), the presence of collateral, the availability of alternative information sources, and other loan contract terms.

Reputation and relationship play a unique role in this decision. As a bank’s relationship with a borrower grows longer, bankers request financial statements less often. However, when that same relationship grows deeper—meaning the borrower takes out more loans—bankers begin to request financial statements more often.

The research comes from this paper, “The Value of Financial Statement Verification in Debt Financing: Evidence from Private U.S. Firms,” Journal of Accounting Research (May 2011). Professor Minnis also has two more interesting working papers on related subjects.  Financial Statements as Monitoring Mechanisms: Evidence from Small Commercial Loans, with Andrew Sutherland, November 2013 and Financial Reporting Choices of U.S. Private Firms: Large-Sample Analysis of GAAP and Audit Use, with Petro Lisowsky, December 2013 are interesting. (The supplemental appendix for the November paper is available here.)

One key to understanding the power of this very large yet hidden economy is finding good, verifiable financial information about private firms.

From this article:

It’s difficult to find out because financial data is not publicly available for private firms the way it is for companies listed on a stock exchange. Most private firms do not have extensively public reporting requirements. Therefore, they are not required to follow generally accepted accounting principles (GAAP), produce audited financial statements, or report their results publicly. As a result, researchers are often unable to readily obtain financial data for private companies of all sizes, including pre-IPO companies, the new “emerging growth company” category created by the Jumpstart Our Business Startups (JOBS) Act, and companies owned by private-equity firms.

The trend is to make even less information available to investors, and researchers, regarding the financial viability and the financial controls in force at private firms of all sizes. The excuse is often something about “too much regulation” inhibiting “jobs and growth.”  Remember that next time someone has a hot IPO or private placement deal for you.

The second article in the Summer 2014 issue also deals with disclosure, the kind we as investors and taxpayers should have more of. Research by Chicago Booth Professor Haresh Sapra and the University of Pennsylvania’s Itay Goldstein is cited in my article, “Bank stress tests: How much do we need to know?”

Sapra and Goldstein “caution that while the tests are valuable, regulators should be careful about how much information they disclose about individual institutions. ”

“The Fed’s ultimate decision about stress test disclosure rests on the prioritization of its macroprudential and microprudential goals.”

If microprudential stability of individual banks is a priority, individual results must be disclosed. In my opinion, regulators must mitigate unintended consequences but the disclosures should be made. Anat Admati, a professor of finance and economics at Stanford University’s Graduate School of Business and author of “The Bankers’ New Clothes,” agrees. “Hiding from reality and providing public support to banks that cannot otherwise survive…is dangerous and expensive.”

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