Bank Loans to Distressed Firms: Cronyism, bank governance and economic crisis

Abstract

Loans to financially distressed firms contributed to Korea's 1997 crisis. Possible explanations for these loans include bank's better inside information on borrowing firms, crony lending, and financial institutions' (FI) moral hazards (FIs' poor governance). We examined 6474 non-financial firms' capital structures during 1990-2000. Firms in distress or with higher leverage growth rates tended to show lower expost ability to pay debt, and lower return on assets, suggesting that lending decision is not based on inside information. Even after controlling for available collateral, size and industry effects, distressed firms with large business group (chaebol) affiliation showed the highest borrowing growth rate without proportionately more short-term loans, suggesting crony lending or government guarantees. Distressed firms with FI affiliation showed a higher leverage growth rate, consistent with the related lending argument. Distressed non-chaebol firms without FI affiliation also showed higher leverage growth rates and with proportionately more short-term loans. However, their ex-post performance was lower. These results show that banks lent to these small firms without affiliation to chaebols nor FIs despite the lack of external pressure, suggesting poor governance at the FIs.