Can banks monitor small business borrowers effectively using hard information?

We investigate whether banks rely on hard information to monitor small business borrowers and to what extent hard information is credible. Using Japanese firm‐level data, we show that banks reduce the amount of lending to defaulting firms if the firms are financially distressed and suffer operating losses. In contrast, banks do not significantly reduce the amount of lending to defaulting firms with low levels of leverage and high profitability. This implies that banks mitigate type II errors if they receive default signals using the hard information of informationally opaque small businesses.