Loans to distressed firms: Political connections, Related lending, Business Group Affiliation and Bank Governance

Abstract

Financial institutions (FIs) suffered from non-performing loans when debt-ridden firms failed. Nonetheless, FIs in Korea increased loans to distressed firms in the 1990s. Possible explanations for these loans include FIs having better inside information on borrowing firms, firms' sharing resources with its business group affiliated firms, firms' political connections, related lending (FI affiliation), or FIs' moral hazards (poor FI governance). We examined 6, 474 non-financial firms' capital structures and performances during 1990-2000. Distressed firms had higher leverage ratios and leverage growth rates. Furthermore, firms in distress, with higher leverage growth rates or political connections tended to show both lower ex-post ability to pay debt and lower return on assets, suggesting that FIs did not benefit from inside information when making lending decisions regarding distressed firms. Firms in distress, with political connections, or with FI affiliations all had higher leverage growth rates. Among distressed firms, those affiliated with business groups had higher leverage growth. Together, these results support the claims that business group affiliations, political connections, and related lending affected lending practices. Distressed firms without any business group affiliations, political connections, or FI affiliations also showed higher leverage growth rates, supporting the claim of poor FI governance.