Who Borrows? Firm Performance Predictability of Bank Lending Decisions to Small Firms

Abstract

We investigate two questions: (1) Do bank lending decisions to small and medium-sized firms provide information about these firms' future financial performance? (2) Does this predictability vary across different stages of the credit cycle? Based on a unique, detailed data set of all Norwegian firms' bank accounts and financial statements, the answer to both questions is yes. Competing 'outside' bank lenders lend to firms who subsequently perform worse than other borrowers, and this relationship is primarily present in the expansionary stages of the credit cycle. This suggests that a firm's current bank lender has private information about its borrowers, while 'outsider' banks face a "winner's curse" when approached by new loan applicants. The finding that this primarily occurs in credit cycle expansions is consistent with theory models that predict that banks reduce screening of new borrowers in these periods, leading to lower average credit quality of bank borrowers when growth in aggregate credit is high.

Keywords: bank lending, bank relationship, business cycles, information asymmetry

JEL Classification: G21,G32