The Effect of Bank Monitoring on the Demand for Earnings Quality in Bond Contracts

We investigate whether bank monitoring that relies on private information in private debt decreases the demand for earnings quality in public debt. In doing so, we focus on Japanese main banks that have high abilities to access the private information of borrowing firms. We find that under stable financial conditions in the bond-issuing firms, accruals quality is negatively associated with bond yield spreads, regardless of the existence of a main bank, suggesting that reporting higher quality earnings affects the reduction of the cost of debt in public debt. In contrast, we find that when the bond-issuing firms with a main bank have high default risk, there is no relationship between accruals quality and bond yield spread. The results suggest that when a main bank has a stronger incentive to monitor their borrowing firms due to the firm's poor financial performance, the increased bank monitoring using private information decreases the demand for earnings quality in bond contracts.