The expert's edge? Bank lending specialization and informational advantages for credit risk assessment

We examine whether loan portfolio sectoral specialization provides informational advantages to banks, enabling better credit risk assessment. Using euro area credit register data, we compare probabilities of default assigned by specialized and non-specialized banks to the same borrowing firm several quarters before the borrower defaults. We find that banks specialized in the borrower's sector are better in predicting future defaults. This is mostly driven by specialized banks actively raising probabilities of default earlier, not by higher probabilities of default when loans are issued. As a result, specialized banks also increase provisions to these borrowers. We do not observe differences in credit risk assessment towards healthy borrowers, suggesting that the effect is not attributable to general conservatism but to more accurate evaluation of credit risk in the sectors of banks' specialization. Our results are more pronounced for smaller firms and when banks do not have long-term relationships with their defaulting borrowers.