Institutional Differences and International Private Debt Markets: A Test Using Mandatory IFRS Adoption

• Author: ANNA BERGMAN BROWN
• Published date: 01 June 2016
• DOI: http://doi.org/10.1111/1475-679X.12111
• Date: 01 June 2016

DOI: 10.1111/1475-679X.12111

Journal of Accounting Research

Vol. 54 No. 3 June 2016

Printed in U.S.A.

Institutional Differences and

International Private Debt Markets:

A Test Using Mandatory IFRS

Adoption

ANNA BERGMAN BROWN

∗

Received 19 December 2013; accepted 24 January 2016

ABSTRACT

Institutional differences between countries result in additional information

risks between borrowers and lenders in cross-border private loans. This study

examines the effect of these information risks on the structure of optimal

debt contracts in international (cross-border) versus domestic private debt

markets. Using mandatory IFRS adoption as an indicator for institutional

changes that reduced differences between countries, I compare attributes of

international versus domestic loans before and after IFRS adoption. I find

that, in the pre-IFRS period, international loans are associated with a higher

credit spread, a weaker relationship between the bank and the borrower, a

more diffuse loan syndicate, and less reliance on accounting-based covenants

∗Jon M. Huntsman School of Business, Utah State University.

Accepted by Christian Leuz. This paper is based on my dissertation from Baruch

College, City University of New York. I am especially grateful to an anonymous re-

viewer and my dissertation co-chairs, Donal Byard and Carol Marquardt, for many help-

ful comments and suggestions. I would like to thank Linda Allen, Hans Christensen,

Paquita Davis-Friday, Edward Li, Yinghua Li, Brigitte Muehlmann, Chad Simon, Ryan

Wynne, Emanuel Zur, participants at the 2013 AAA Northeast Regional Meeting, 2014

AAA International Section Meeting, and 2014 AAA Annual Meeting, and workshop par-

ticipants at the College of William and Mary, Concordia University, Idaho State Univer-

sity, and Utah State University for their helpful comments and suggestions. All errors

are my own. An online appendix to this paper can be downloaded at http://research.

chicagobooth.edu/arc/journal-of-accounting-research/online-supplements.

679

Copyright C, University of Chicago on behalf of the Accounting Research Center,2016

680 A.B.BROWN

than domestic loans. These results are consistent with incremental informa-

tion risks in international debt markets that make it more costly for lenders to

screen and monitor borrower credit quality, resulting in a more arm’s-length

relationship between borrowers and lenders. Many of these associations at-

tenuate after IFRS adoption, suggesting that the pre-IFRS differences in con-

tract terms are driven by incremental information risks related to institutional

differences between countries. My findings imply that incremental informa-

tion risks result in a different optimal contract in international debt contracts

compared to domestic debt contracts.

JEL codes: D86; F34; G15; M41

Keywords: information risks; international accounting standards; interna-

tional debt markets; relationship lending

1. Introduction

International lending forms a significant portion of the corporate private

debt market, yet we know relatively little about the tradeoffs borrowers and

lenders face when contracting internationally versus domestically.1Asetof

institutions create the environment within which the optimal debt contract

is determined by contracting parties. Differences in legal systems, financial

reporting standards, property rights, and enforcement between countries

each make it more difficult for lenders to gather and process information

about foreign borrowers compared to domestic borrowers. In international

loans, these institutional differences result in heightened information risks

that change the optimal contract compared to domestic loans. In this study,

I explore the role of such incremental information risks in explaining the

differences in loan terms between international versus domestic private

loans.

Incremental information risks in international private debt markets sug-

gest that international loans will reflect a different optimal contract com-

pared to domestic loans. Lenders contracting internationally as compared

to domestically will experience greater difficulty in (1) screening bor-

rower credit risk (the “due diligence” work) and (2) monitoring of bor-

rower ongoing credit quality over the life of the loan.2Domestic private

debt markets are typically characterized by relationship lending, defined as

1In 2012, 39% of new private loans to public companies worldwide were made by banks

domiciled in a different country from the borrower, representing US$2.1 trillion in interna-

tional lending in 2012 alone. Source: Dealscan from Thomson Reuter’s Loan Pricing Corpora-

tion.

2The home bias literature has documented similar information risks in equity markets:

Investors tend to invest disproportionately in domestic rather than international stocks due

to their domestic or local information advantage (Kang and Stulz [1997], Karolyi and Stulz

[2003], Ahearne, Griever, and Warnock [2004]). This information advantage is typically at-

tributed to the lower information acquisition and processing costs associated with local or

domestic investments.

INSTITUTIONAL DIFFERENCES AND DEBT MARKETS 681

repeated lending to the same borrower to facilitate due diligence and mon-

itoring in order to mitigate information risks (Sharpe [1990], Rajan [1992],

Bharath et al. [2011]). I expect that lenders experience greater difficulty in

screening and monitoring international borrowers due to heightened in-

formation risks, and therefore charge a higher credit spread to offset the

additional information risk in lieu of forming a close relationship with bor-

rowers. I therefore predict that, compared to domestic loans, international

loans will have a higher credit spread and a weaker relationship between

the borrower and the lender (i.e., a more “arm’s-length” relationship). I

also predict that international loans will be characterized by less reliance

on monitoring mechanisms in the form of a more diffuse loan syndicate3

and fewer covenant restrictions.4

The mandatory adoption of International Financial Reporting Standards

(IFRS) in 2005 offers a valuable opportunity to examine the effect of infor-

mation risks on international lending. IFRS mandated the harmonization

of financial reporting standards, thereby reducing one source of informa-

tion friction. However, in many countries, mandatory IFRS adoption also

coincided with other significant institutional changes, including changes in

insider trading laws, filing requirements, and financial reporting enforce-

ment (Christensen, Hail, and Leuz [2013]). Therefore, I use mandatory

IFRS adoption as an indicator for institutional changes that reduced dif-

ferences between countries. These harmonizing institutional changes, in

turn, can be used to study whether incremental information risks arising

from institutional differences affect the differences in optimal loan con-

tracts offered in domestic versus international private debt markets. I use

a sample of private loans for borrowers in 25 countries that mandate IFRS

adoption starting in fiscal year 2005 to perform a difference-in-differences

analysis on the terms of domestic versus international loans before and af-

ter mandatory IFRS adoption.5I define domestic loans as those in which

the borrower and lender (or lead bank) are domiciled in the same coun-

try, and international loans as those in which the borrower and lender (or

lead bank) are domiciled in different countries. This sample allows me to

examine the pre-IFRS period as a baseline for comparing the attributes of

3In the finance literature, a more diffuse loan syndicate generally proxies for the lender

performing less monitoring and due diligence. However, in this setting, there are several pos-

sible alternative explanations. It is possible that the lender forms a more diffuse loan syndicate

in order to delegate risk to other banks in the syndicate. A diffuse loan syndicate could also

serve to deter strategic default by increasing renegotiation costs.

4The debt contracting literature suggests that debt covenants serve as a monitoring mech-

anism by restricting the borrower’s activity and transferring bargaining power to the lender

(Jensen and Meckling [1976], Smith and Warner [1989]).

5Twenty-nine countries mandated IFRS adoption beginning in fiscal year 2005. However,

as there were no loans from Czech Republic or Lithuania that met the criteria for my sample,

my sample of loans represents firms from 27 countries. Furthermore, for two countries, there

is only one loan observation for my sample period. As these countries drop out when I use

borrower country fixed effects, I report my evidence using data from 25 countries.