Financial Condition,Financial Reporting Quality,and Bank's Credit Decisions

In recent years,the domestic commercial bank credit business facing the new development of corporate financial reporting quality problem,mainly in: the financial condition of enterprise earnings reflected in the credit decisions are more and more important;targeted manipulation of financial data is more easily;the low quality of the financial report get more and more access to the bank;the impact of using low quality financial report to make loan decision is more and more broad,the consequences of a single decision's error is becoming more and more serious.In order to deeply understand and try to solve this problem,this paper will divide the affect of the financial reporting quality to credit risk(or loan decision)into two kinds: direct and indirect impact.We also split credit risk to Probability of Default(PD)and Loss Given Default(LGD).Through analyzing the direct and indirect impact of the quality of earnings on the probability of default and the default loss rate,we should determine whether the quality of earnings should be recognized,in order to improve the level of credit management.Finally,this paper studies whether a bank has identified the quality of financial reporting in the decision-making process of loan amount and loan pricing.This paper is divided into three parts: theoretical analysis,literature review,and empirical test.In the theoretical analysis and literature review part,firstly,we introduce the relationship between the financial condition and credit risk of it's loan,according to the description of Basel agreement on credit risk,we split the theoretical and literature review of credit risk into two parts: the relationship between financial condition of enterprises and the probability of default,and the relationship between financial condition of enterprises and LGD.The in-depth analysis of this part of the literature found that,conclusion for correlation between financial condition and the probability of default is the overall consistent,namely the financial condition and the probability of default is highly relevant,and this relationship is nonlinear,and must be considered comprehensive within all financial ratios(not separately).The relationship between the financial condition and default related losses are not as clear as the relationship between the financial condition and the probability of default.Especially different in the research method.There is barely no study that introduces a large number of financial ratios into the model of analyzing LGD.We believe that the current research still lacking the exploration of how LGD is related to the financial condition.Secondly,this paper analyzed the “direct effect” and the “indirect effect” on the quality of financial report with credit risk.Through the review of studies of the relationship between financial reporting quality and the credit risk,we conclude that many researchers found some evidence on “direct effect” and “indirect effect”.We found that the current researches still have some large blanks,including: little attention to reporting quality and LGD,the weak theory of financial report's “direct effect” on the credit risk,and the narrow research sample that only including listed public companies.Thirdly,based on whether the bank s have used financial condition and reporting quality for loan decision-making,conclusion is consistent in whether banks have used them to make loan decision,but not consistent in which indexs are used by the banks.After finishing the literature review,we believe that the main defects of the current study in relationships between financial condition,financial reporting quality and banks' decisions include: studies stay in the surface of the problem,like whether there is a correlation between the credit decision and financial condition.Therefore,we only know that the bank is using some certain financial indexes to make credit decisions,but we have little knowledge on which financial indicators(short-term solvency,long-term solvency,profitability,operating ability)are used for which type of decision-making(loan amount,price,warranty),let alone further evaluation of the adequency for banks using some certain financial indexes.The main defects of the current study on financial reporting quality and banks' credit decision include: the research perspectives are always result oriented;the studies do not distinguish between the direct effect and indirect effect of financial reporting quality;the stud ies failed to develop a universal methodology for any bank to evaluate its ability of indentificating financial reporting quality.At the end of the literature review,we sorted out the main methods of the financial reporting quality measurement,and estab lished the theoretical foundation for the measurement of the proxy variables of financial reporting quality used in this paper.In the empirical part,this paper uses samples from X bank between 2008-2014,the research is mainly related to four key issues:Firstly,whether the financial condition(reflected in an audited annual report provided by the enterprise)can effectively predict the credit risk,including the probability of default and LGD.The results show that most indicators in the default group and non-default has significant differences in distribution,supporting our hypothesis that the financial condition of enterprises has predictive value on the PD.The results also show that some financial indicators have significant effects on t he distribution of LGD,and therefore have forecasting value on LGD.Secondly,what kind of(direct or indirect)impact did the financial reporting quality make on loan's credit risk.The results show that: the quality of financial reporting has a significant direct impact on the PD,most of the quality features can be and should be used by banks to forecast the PD.Also,the financial reporting quality can indirectly affect PD by representing the authenticity,relevance and reliability of the financial condition reflecting in the financial report.Low quality features of financial report will impede a bank to use the financial condition obtained from from the financial report,and then may distort the accuracy of predicting PD.Part of the reporting quality features a lso has significant direct impact on LGD.Those features include the proportion of old accounts receivable,the audit opinion.Results on whether financial reporting quality has indirect impact on LGD are not as clear as the above conclusion.For enterprises with lower earnings quality,the link between financial condition and LGD are weakened.But for enterprises with more aged accounts receivable,or with qualified audit opinion,the relationship between the financial condition and LGD is stronger.Thirdly,what kind of method can a bank use to judge whether its' loan decision are made based on the reasonable financial indexes.We put forward the financial index correlation analysis as a method for banks to use: compare(1)the common factorsof financial indexes which banks should use(PD judgment: factor1,LGD judgment: factor2),to(2)common factors of the most effective financial index judgment of credit risk a common factor of using financial index and X bank with real to make the credit decision of(a mount of decision Factor3;factor4;interest rate decision: guarantee decision factor5).We make correlation analysis between those five factors,to determine if the bank's decision is using the reasonable financial indexes,or not.Fourthly,what kind of method can a bank use to judge its adequency on enterprises' financial reporting quality recognition.We calculated a bunch of financial reporting quality features(variables)in this paper.According to the relationship between those variables and credit risk,we conclude the “should be” effect of the financial reporting features if they appear.Then,we propose a bank's “should be” countermeasure on every financial reporting quality feasture's appearance.Then compared the “should be” countermeasure with bank X's “actual” countermeasure,to see whether there is any gap on bank X's recognition of financial reporting quality.In this paper,we mainly focus at the quality of the financial report,and links it to financial condition of enterprises,credit risk,bank decision-making.Separate its impact on credit risk into direct and indirect.Through theoretical analysis and empirical test,we investigate the banks ablity to recognize quality of financial report in their loan-decision-making process.We also establish two method(“corrletion analysis” and "gap analysis”)for banks to judege their adequency,ablity of using enterprises' financial condition and financial reporting quality features.