This study explores the bank lending decision puzzle in Chinese listed firms. Banks are known to play a certification role for borrowing firms, reflected by loan announcements generating abnormal positive returns for borrowing firms in stock markets. In contrast, negative market reactions towards the bank loan announcements exist when Chinese firms borrow. If Chinese banks make efficient lending decisions, why do Chinese banks not provide certification for borrowing firms? This thesis focuses on whether and how banks treat earnings management in borrowing firms when they make lending decisions. I predict that banks may not always exert effort to detect earnings management and the observed positive relationship between loan size and firm profitability is due to earnings management.
Using firm performance before and after adjustment for earnings management, I am able to investigate whether banks examine the credibility and reliability of reported earnings of borrowing firms. I find that, when firm performance is adjusted for earnings management, it is no longer related to bank loan size in some cases. Specifically, the positive relationship between bank loan size and firm performance disappears for loans by state owned banks to state owned enterprises (SOE) and loans by small and medium sized banks to both SOEs and non-SOEs.
These findings show that bank-lending decisions vary according to bank-firm ownership relationships and without real screening effort, banks fail to provide certification value to borrowers
