What's Bank Reputation Worth? The Effect of Fraud on Financial Contracts and Investment

The risk of a reputation loss can provide an informal enforcement mechanism when contracts are incomplete. This paper provides evidence that reputation and formal incentives to monitor are substitutes in the context of syndicated credit. Monitoring in a loan syndicate is delegated to lead banks, whose formal incentives are determined by their share of the loan. Exploiting as a source of variation the reputation loss suffered by banks actively lending to firms subsequently involved in fraud scandals, we use within-firm estimators to show that monitoring banks face higher-powered contracts—higher loan shares—after a reputation loss. Despite this substitution, banks supply less credit and borrower financial policy and investment are affected, indicating that formal incentives are an imperfect substitute for reputation.