Parsing the Evidence of the Financial Crisis 2007-9

During the recent crisis, bank lending to firms declined: loan issuances dropped 75 percent, and the probability of obtaining a loan fell by 14 percent.

In Which Financial Frictions? Parsing the Evidence of the Financial Crisis 2007-9 (NBER Working Paper No. 18335), co-authors Tobias Adrian, Paolo Colla, and Hyun Song Shin revisit a long standing debate about whether financial frictions manifest themselves through shocks to the demand for credit -- deterioration of creditworthiness of borrowers -- or shocks to the supply of credit -- tighter lending criteria applied by the lender. Using both aggregate data from the Flow of Funds and firm-level data from COMPUSTAT and other sources, they argue that the evidence from the recent crisis overwhelmingly points to a shock in the supply of intermediated credit by banks and other financial intermediaries.

During the recent crisis, bank lending to firms declined: loan issuances dropped 75 percent, and the probability of obtaining a loan fell by 14 percent. At the same time, though, bond issuances increased. Large, rated firms with access to the bond market were able to compensate for the reduction in bank lending by increasing their borrowing from the bond market, leaving total financing unchanged. In contrast, bank-dependent firms suffered a reduction in bank financing without being able to tap the bond market; they witnessed a marked decrease in the amount of new credit. This analysis highlights the fact that firm attributes are an important determinant of the effect of a financial shock. The authors find that firms with more tangible assets, higher credit ratings, better project quality, fewer growth opportunities, and lower leverage, were better equipped to withstand the contraction of bank credit during the crisis.

The authors document five "stylized facts" that need to be explained in any model of financial frictions. 1) Both bank and bond financing are quantitatively important for non-financial corporations. 2) In downturns, bank loans contract, but bond finance increases to make up most of the gap. 3) Credit spreads for both bank loans and newly-issued bonds rise during downturns. 4) Changes in debt issued by banks are reflected nearly one-for-one in bank lending. 5) Bank leverage is procyclical. They conclude that models of financial frictions need to recognize that the impact of credit on real activity is largely the result of sharply rising risk premiums during a financial crisis, rather than a direct effect of a contraction in the total quantity of credit.

--Claire Brunel