DP9934 | Does Relationship Lending Require Opaque (and Conservative) Financial Reporting?

Publication Date

13/04/2014

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Abstract

For many private firms, relationship lending is the only viable form of outside financing. Relationship lending typically relies on intertemporal loan pricing: losses from early years are recovered by information rents in later years, which stem from the lender's private information regarding the firm's creditworthiness. Our model shows that overly transparent financial reporting reduces the relationship lender's information rent such that the lender has insufficient incentive to offer early stage financing as a result. During financial distress, private firms find it easier to obtain liquidity support from relationship lenders when financial reporting is sufficiently opaque. Conservative opacity enables relationship lending more effectively than aggressive reporting. This paper seeks to explain why private firm financial reporting is (conservatively) opaque and raises concerns regarding recent regulatory efforts that require private firms to engage in more transparent financial reporting because such efforts may result in undesirable side effects.