What is the effect of making credit information public when borrowers find themselves close to financial distress? A creditor's decision to continue to finance a firm depends on both uncertain borrower creditworthiness and the expected decisions of other lenders. A creditor has less incentive to continue financing if she believes that other creditors are about to withhold financing. This occurs because the lack of credit from one creditor can potentially disrupt the operations of the firm, making it less profitable for other lenders to extend credit. This creates an incentive for lenders to coordinate — that is, to lend only to firms that they believe will not have any problem obtaining funds from any of their other lenders.
Since lenders have an incentive to coordinate their financing choices, these choices become highly sensitive to public news because it helps forecast actions other lenders are likely to take. As a result, if bad news is released publicly it can make firms more vulnerable to a creditor run, in which each lender withholds financing from a firm because they believe other banks will do the same. A firm can be forced into financial distress despite the fact that fundamentals of the business would still profitable if it could obtain enough short-term credit. Releasing public information can have a similar effect in triggering bank runs and currency attacks because one investor’s return is affected by the investment decisions of others.
Professors Andrew Hertzberg and Daniel Paravisini, working with José María Liberti of DePaul University, measured the effect of making credit information publicly available by studying the expansion of a public credit registry in Argentina. Public credit registries are government managed databases of credit information on borrowers. Registries exist in 71 countries and often mandate that information about borrowers be shared across banks.
In April 1998, Argentina’s central bank, which receives credit ratings from all of the country’s lenders, announced that it would make all credit reports in its registry public; until then, the central bank had made credit information public only for borrowers whose total outstanding credit liability totaled $200,000 or more.
The researchers compared the lending practices of banks before and after the credit registry threshold was lifted to learn what, if any, effect the change had on banks’ use of information. The researchers studied small to medium-size firms, limiting their study to those that borrowed between $175,000 and $225,000.
They found that the newly public credit reports affected the relationship between the lenders who gave poor ratings and the borrowers who received them. Before the credit registry was public, a lender would proceed more cautiously with a firm that had received a bad rating, but would not terminate its lending. After the credit registry was made public, anticipating that other banks would be less likely to extend credit to firms it had rated poorly, lenders decreased their lending to borrowers with low ratings.
In the month following the registry expansion, lenders who had reported poor credit ratings reduced their lending, on average, by 15 percentage points. In their preemptive move, lenders refused to provide liquidity, which serves as an emergency loan for a firm that may be short on cash. As a consequence, default by their borrowers increased by 13 percentage points.
“We found a disruption in liquidity injections,” Paravisini says, “which run dry after the registry expansion is announced.” On average, firms whose credit information was shared through the registry experienced a significant decline in their total debt.
“Though we’re seeing increasingly volatile lending decisions,” Paravisini says, “there are positive aspects to forcing banks to share information.”
For example, a registry allows lenders to know if a firm is borrowing elsewhere or if the same collateral has already been pledged to another lender. In most developed countries, including the United States, credit information sharing is not mandatory. However, the same effect can occur with other public sources of credit information such as bond ratings and analyst forecasts.
“Because of the current financial crisis, government intervention in financial-market regulation is going to be a key topic,” Paravisini says. “The potential effects of making credit ratings public — positive and negative — are an important force to keep in mind.”
Andrew Hertzberg is assistant professor of finance and economics at Columbia Business School.