Do Banks Predict Financial Restatements? Evidence from the Secondary Loan Market

The number of financial restatements has grown significantly in the last decade. Financial restatements decrease investors' perception of firms' future cash flow, and increase uncertainty about the credibility of firms' financial statements. In this paper, we examine financial restatements from the debtholder's perspective by investigating how the secondary loan market, a hybrid of a private and a public market, react to financial restatements. Through event studies, we find the secondary loan market shows significant negative abnormal returns and increased bid-ask spreads one month prior to restatement announcements as well as restatement announcement periods, which support both the liquidity and the private information hypotheses of the secondary loan market. The cross sectional regression shows that loan market reacts more negatively to restatements with revenue recognition issues and restatements initiated by the SEC and auditors. Furthermore, by examining different stock market reactions to restating firms who trade in both the equity market and the loan market, and who trade only in the equity market, we find the restatement information arrives the secondary loan market earlier than the equity market due to the role of banks as insider lenders, and such private information can quickly flow into the equity market, which supports the integration markets hypothesis. Finally, we find significant negative abnormal stock returns for the lead lending banks when their borrowers announce restatements. It shows lead banks are punished by outside investors because of their role as insiders and monitors. Our study provides comprehensive evidence on the uniqueness of the secondary loan market.