Summary:
How geographic distance affects economic activities is an important issue. Studies have provided evidence that geographic proximity plays an important role in bank lending, venture capital investing, analyst forecasts and the stock returns of fund managers, indicating that it facilities monitoring and access to information. However, all of these findings are based on arm's-length transactions. Due to the data limitations of internal capital markets, determining the extent and mechanism of the effect of geographic distance on the loan contracts of intra-group loans is difficult. Little, if anything, is known about the prevention of loan risk in internal capital markets. In particular, China is a country with a vast territory, so firms affiliated with business groups are widely geographically distributed. In this study, we attempt to determine how geographic distance affects the loan contracts of intra-group loans. This offers insights into the behavior of lenders and borrowers in dealing with loan risk in internal capital markets, thereby developing an understanding of the micro-foundation of capital allocation in internal capital markets. The China Securities Regulation Commission requires listed firms to disclose all of their entrusted loans in official documents. Many of these entrusted loans are loans between affiliated companies within business groups, which is a typical means of capital allocation in internal capital markets. Therefore, detailed information on loan contracts and the locations of lenders and borrowers is available. We manually collect detailed information on entrusted loans, including loan terms, such as interest rate, maturity, amount, collateral and loan purpose, and defaults. Using Google Earth to identify the latitudes and longitudes of firms' addresses, we calculate the aerial distances between the geographic coordinates of affiliated companies within business groups. Using a hand-collected dataset of entrusted loans within business groups in China, we examine the effects of geographic distance on loan contracts and loan risk, focusing on the role of information. We find that contracts tend to be more restrictive when firms seek loans from remote lenders: lenders not only demand collateral, but also restrict loan purposes. Consistent with the notion that an increase in distance makes it harder for lenders to monitor borrowers and gather soft information, our results strengthen when the information friction between borrowers and lenders is greater. Furthermore, the results based on borrower default data indicate that dynamically adjusting the severity of contracts to cope with information asymmetry effectively reduces the risk of default. We contribute to both the literature on the role of geographic distance in economic activities and the literature on firms' capital allocation in internal capital markets. First, we provide direct evidence that geographic distance plays a significant role in loan contracts in internal capital markets. This means that the information collecting and monitoring associated with distance are important determinants of capital allocation in business groups. Thus, we enhance understanding of the influence of geographical distance on internal capital allocation. Second, we are the first to investigate the effect of geographic distance on intra-group loan contracts using hand-collected data on entrusted loans in internal capital markets in China. We find that loan contracts become more restrictive as the distance between borrowers and lenders increases. Furthermore, strict contractual arrangements effectively reduce loan risk. These findings shed new light on how to prevent loan risk through loan contracts. They also deepen understanding of the internal loan contract design, which is of great significance to effectively controlling operation risk in internal capital markets.
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