Abstract

Under an enriched notion of "inside debt", state-controlled banks may lend to both viable borrowers and to weak firms to avert unemployment and social instability. Negative price reactions to bank loan announcements should result if weak borrowers are prevalent. Confirming this prediction, we find significantly negative event-study responses for Chinese borrowers, unlike positive responses previously found for U.S. borrowers. Negative responses typify borrowers with frequent related-party transactions, poor subsequent performance, high state ownership, loans from the four major state banks or local bank branches, or loans to repay existing debt. Poorer financial performance and higher managerial expenses increase the likelihood of obtaining bank loans. Our results demonstrate the conflicting goals and resulting problems of reforming a transitional financial system.