Abstract

In this paper we study the economic role of banks’ soft information, evolved from repeated lending relationships, in the context of loan default. Using a proprietary database from one of the largest state-owned commercial banks in China, we find that the bank’s internal credit rating scores substantially improve the accuracy of default prediction. While the internal credit rating does incorporate firm-specific hard information such as financial ratios derived from financial statements, it is the soft information component of these ratings that contributes to the improvement in assessing credit quality. In addition, to what the extent that soft information prevails over hard information depends on the depth of the lending relationship. When evaluating loan delinquency, a strong lending relationship allows soft information to substitute, rather than complement, the role of hard information, especially the hard information that is subject to easy manipulation by Chinese firms.