Does soft information determine credit risk? Text-based evidence from European banks

This paper uses a supervised machine learning algorithm to extract relevant (soft) information from annual reports and examines whether such information determines credit risk (as measured by non-performing loans, Ohlson’s O-score, Altman’s Z-score, and credit rating downgrades). The paper also assesses how far both bank- and country-level characteristics influence variations in credit risks both within and between banks across 19 European countries between 2005 and 2017. Based on 1885 firm-year observations, we find that the text-based credit risk (soft) measure explains a substantial portion of the variation in NPLs, O-score, Z-score, and credit rating downgrades. We also find that bank-level characteristics and country-level characteristics are highly important for explaining variations in non-performing loans, O-score, and credit rating downgrades, as compared to Z-score. Overall, our results have implications for firms, regulators, and market participants who are seeking evidence on the credibility of annual reports in conveying relevant information that reflects actual credit risk.