Bank Monitoring of Borrowers and Borrowers’ Investment Efficiency: Evidence from the Switch to the Expected Credit Loss Model

Abstract

The recent switch from the incurred credit loss model to the expected credit loss model is an important change to bank financial reporting systems around the world. The expected credit loss model requires banks to monitor their borrowers closely for more timely recognition of loan losses. We posit and find that this close monitoring of potential loan losses enhances borrowers’ investment-q sensitivity, consistent with such monitoring enhancing borrowers’ investment efficiency. This effect is stronger for borrowers with greater bank dependence. It is also stronger in environments where banks themselves face more intense regulation and monitoring, indicating that the monitoring effects from regulation spill over to banks and then to borrowers. Overall, our study provides the novel insight that changes in the intensity of banks’ monitoring of borrowers due to their financial reporting system can have real effects on their borrowers.

Keywords: expected credit loss model; loan loss recognition timeliness; bank monitoring; investment efficiency

JEL Classification: G21, G28, G31, G38, H25, M41