30 January 2019

ECB working paper: Some borrowers are more equal than others: bank funding shocks and credit reallocation

This paper studies the reallocation of credit within the domestic credit portfolio of banks after a negative funding shock. The particular shock authors focus on is freeze of the interbank funding market around the Lehman collapse.

To identify the reallocation in the supply of credit following these funding problems, they rely on 160,223 fully documented bank-firm combinations for nearly all banks and non-financial firms active in Belgium.

They start by documenting the average impact of interbank funding shock on bank credit supply. A firm borrowing from a bank hit by a funding shock of -10.3% (the average shock in the sample) has a 6.04 percentage points lower probability of seeing an increase in granted credit (sample mean is 28.9%). At the aggregate level, their results imply a reduction in credit supply of EUR 4.2 billion during the year after the Lehman shock.

However, not all borrowing firms are being hit equally hard. Banks’ sector presence and sector specialization determine the reallocation of credit when a bank is hit by a negative funding shock. Sector presence measures how important a bank is for a particular (non-financial) sector while sector specialization measures how important a (non-financial) sector is for a bank.

Authors find that a standard deviation increase in sector presence reduces the negative impact of the funding shock on credit supply by 22% for the average firm. Similarly, a standard deviation increase in sector specialization reduces the negative impact of the funding shock on credit supply by 8% for the average firm. Hence, banks direct their attention to sectors where they can more easily extract rents (higher sector presence) or where they have built up superior knowledge (higher sector specialization).

Additionally, we document the existence of a flight to quality. Banks reallocate credit towards firms with low debt levels, low default risk, high available collateral, and a high interest coverage ratios. Importantly, this flight-to-quality coexists with the two aforementioned reallocation effects.

The reallocation effects are robust to a number of alternative explanations. They provide evidence that their results are not driven by pre-shock solvability problems, government interventions during their sample period, banks’ geographical specialization, or bank-firm relationship characteristics.

On the real side, authors find a moderate reduction in investments and asset growth for firms borrowing from banks that were hit harder by the funding shock. The average firm borrowing from a bank that experienced an average funding shock reduced its net investment rate by 0.85 percentage points. Importantly, they show that firms that are borrowing from a bank with high sector presence can partially offset this negative impact on investment rates.

Their results provide useful information for policy makers that want to ensure access to finance for non-financial corporations during crisis times, as they show that riskier firms and firms borrowing from banks that have low sector presence and specialization are more vulnerable to shocks in the banking sector. Related to this, firms may prefer matching with banks with a larger sector presence as the implied higher cost of borrowing during good times also acts as an insurance premium that guarantees access to finance when the bank faces a funding shock.

Their findings also contain interesting information for bank regulators. Their results reveal a bright sight of lending concentration during crisis times and are thus informative when making the trade off between portfolio concentration risk and having sufficient information about borrowers.

Working paper

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