Loan relation with foreign banks and information asymmetry: evidence from earnings management by local firms in Korea

Previous research shows that foreign (domestic) banks rely more on ‘hard’ (‘soft’) information in their lending decisions and such approaches may give a motivation for the local firms to improve their credit scores by, for example, overstating earnings. The paper develops a theoretical model and empirically tests the model using actual data from Korea. The model predicts that local firms tend to overstate earnings when they increase the loan relations with foreign banks and the proportion of local firms with earnings management increases as the recoverability of foreign banks decreases (increases) in the higher (lower) level of recoverability. The results of the empirical test are consistent with the predictions by the model. We also discuss the implications of the study and an extension for the future study.