Do Banks Always Make Informed Loans? ---a Canadian Study

Bank lending is an important investment activity in an economy. It is widely held that banks are well informed about their borrowers, and banks use such information in their lending decisions to preserve the qualities of their loan portfolios. In this study, we propose a model of the interplay between banks and financial analysts who follow their stocks, and characterize equilibrium with a view to examine how diversely able (heterogeneous) banks lending to the same customer may impact banks’ loan decisions. Distinguishing between H-banks and L-banks, those with high or low lending ability, respectively, we illustrate how two factors can work to bring an L-bank to act rationally against its valuable signal about its borrower in its loan decision-making, thereby blunting the claim of informed lending by banks. The factors are: 1) the asymmetry arising from banks having private information about their own lending abilities; and 2) the concern of the banks to have financial analysts assess favorably such abilities. After identifying the equilibrium conditions under which L-banks would make uninformed loans, we test the model’s implications using a sample of Canadian bank loan announcements. Our results reveal that while we confirm the well-documented evidence that bank financing in general conveys information about the borrowers, we also find support for the key predictions of our model: 1) the bank-financing announcements cause market reactions that are the strongest for deals involving single banks only, as opposed to multiple banks; 2) market reactions to bank financing are inversely related to the borrower firms’ prior prospects, indicating that bank financing agreements convey most information only for uninspiring borrower firms. These results shed some light on bank lending practices in Canada.