What’s Bank Reputation Worth? The Effect of Fraud on Financial Contracts and Investment

The risk of a reputation loss can provide an informal enforcement mechanism when contracts are incomplete. This paper provides evidence that reputation and formal incentives to monitor are substitutes in syndicated lending. Formal incentives in a loan syndicate are determined by the amount of funding the monitoring bank provides to a loan. Using within-firm estimators, we show that monitoring banks increase their funding supply after a reputation loss caused by the discovery of fraud by one of its borrowers. Despite the substitution towards higher contractual incentives, overall credit supply declines, suggesting that formal incentives are an imperfect substitute for reputation. ∗Lin: IMF. Paravisini: Columbia University GSB, NBER, and BREAD. The views expressed herein are those of the authors and should not be attributed to the IMF, its Executive Board, or its management. Paravisini acknowledges the support of the FDIC-CFR. We thank Adair Morse for sharing the fraud data. This draft has benefited greatly from comments from Abhijit Banerjee, Nittai Bergman, Patrick Bolton, Serdar Dinc, Matthew Gentzkow, Andrew Hertzberg, Raj Iyer, Wei Jiang, Atif Mian, Francisco PérezGonzález, Mitchell Petersen, Verónica Rappoport, Avri Ravid, Roberto Rigobón, David Romer, Tano Santos, Antoinette Schoar, Ramana Sonti, Neng Wang, Daniel Wolfenzon, and all the participants in the Board of Governors of the Federal Reserve Bank, DePaul University/Chicago Federal Reserve Bank, IMF Research, New York Federal Reserve Bank, Northwestern Kellogg, San Francisco Federal Reserve Bank, Rochester Simon GSB, and Yale SOM finance seminars, the Columbia GSB, FDIC-CFR, and MIT Sloan finance and economics workshops, and the NBER Fall Corporate Finance, Washington University Corporate Finance, and Western Finance Association conferences.