Bank Monitoring Incentives and Borrower Earnings Management: Evidence from the Japanese Banking Crisis of 1993-2002

Abstract

We examine banks' disincentives to monitor borrower earnings management activity during the Japanese banking crisis of 1993-2002. We show that during this period, a period characterized by significant deterioration in the financial health of the Japanese banking sector, firms that borrow a large amount of short-term loans from their main bank manage earnings more aggressively around public equity offerings. This result derives largely from the subsample of offerings by poorly performing firms that maintain lending relationships with main banks that are in weak financial health. We also find a significant decrease in post-offering short-term lending by the main banks for firms that manage earnings upward prior to the offerings. In contrast, we do not find such results during the boom period of 1983-1992. Our results suggest that, when they are under great pressure for survival, Japanese main banks have few incentives to monitor corporate managers, and act primarily in the interests of short-term creditors.

Keywords: Main banks, Short-term creditors, Monitoring, Lending relationship, Public equity offerings, Earnings management, Discretionary current accruals.

JEL Classification: G21, G34, M41