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«Rajkamal Iyer Samuel Lopes José-Luis Peydró Antoinette Schoar June 2010 Abstract We analyze the effects of the 2007-09 banking crisis on the supply ...»

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Rajkamal Iyer Samuel Lopes José-Luis Peydró Antoinette Schoar

June 2010


We analyze the effects of the 2007-09 banking crisis on the supply of credit to

businesses. We use loan level data for the entire banking sector from Portugal,

matched with firm and bank information. We exploit a shock to bank liquidity

induced by the unexpected freeze of the European interbank market in August

2007. Using a difference-in-difference approach, we compare lending before and after the crisis by banks with different susceptibility to the shock, based on their exposure to the interbank market prior to the onset of the crisis. In addition, we use firm fixed-effects to control for unobserved heterogeneity in firm loan demand and risk. For the same borrower, banks that rely more on interbank finance before the crisis decrease their lending more severely during the crisis.

The credit supply reduction is stronger for smaller, younger firms, with weaker banking relationships. Moreover, we show that these firms cannot compensate the reduction in supply via obtaining credit from other, less affected, banks, nor from other sources of debt. Finally, we find no reduction in credit supply for large firms. Our results, therefore, suggest that the liquidity shock at the onset of the financial crisis of 2007-09 affects entrepreneurial firms most severely, while larger more established firms were less affected.

Keywords: Credit crunch; credit supply; banking crises; interbank markets;

entrepreneurship; access to credit for small and medium firms; the 2007-09 crisis, flight to quality.

JEL codes: G01; G21; G28; G32.


1 E-mails: riyer@mit.edu; samuel.lopes@ecb.europa.eu; jose-luis.peydro-alcalde@ecb.europa.eu (corresponding author), and aschoar@mit.edu. Any views expressed are only those of the authors and should not be attributed to the Bank of Portugal, the European Central Bank or the Eurosystem.    1

1. Introduction The developed world has experienced the worst financial crisis since the Great Depression which was at its core a banking crisis. The main channel through which a banking crisis may affect the real economy relates to the ability of the private sector to access the credit needed to fund investment and consumption. Hence, a key question at the heart of the current financial crisis is whether and how the sudden dry up in bank liquidity impacted the availability of credit. A drop in liquidity for banks may have a direct transmission effect on the supply of credit for firms if firms are unable to substitute with other sources of finance such as loans from other financial institutions, trade credit or others. Furthermore, this channel could be especially relevant in the context of smaller younger (entrepreneurial) firms which usually find it difficult to access funds from other sources since they are more opaque and thus mainly rely on bank financing.

In this paper we study whether and how banks cut back on lending when faced with a negative liquidity shock. What are the margins along which banks adjust their loan portfolios in response to the crisis, e.g. do we observe credit supply contractions across all types of borrowers, or do they disproportionally cut back entrepreneurial firms? Similarly, does the market adjust to fill an ensuing funding gap? For example, do less affected banks use the opportunity to expand loan to credit constraint businesses? If so, viable borrowers would not face binding credit constraints, and there would not be real effects associated to the bank liquidity shock.

While there are a few recent studies that suggest that there might be a direct transmission mechanism of bank liquidity on the availability of credit for firms,2 there


2 See, Paravisini (2008) and Khwaja, and Mian (2008).  

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reduction in credit occurs. Importantly, in the current financial crisis, it is key to understand the role played by bank liquidity in credit supply and whether the impact differs across different type of firms.3 One of main problems in empirically addressing the questions raised above is the difficulty of identifying the causal impact of a bank liquidity shock on loan supply. Liquidity shocks to banks are usually correlated with an underlying change in the overall economic environment, which might adversely affect not only the supply of credit but also the demand for loans from firms and, in general, firm risk.4 Moreover, even if there is a credit supply reduction from an individual financial institution, it would only translate into credit constraints, if firms cannot substitute a credit reduction from the more affected banks with credit from other, less affected, banks (or even from other sources of credit).

To tackle these identification challenges, we use the initial exogenous and unexpected shock to the interbank markets in August 2007. The crisis started in August 2007 in Europe when the interbank market, a crucial source of liquidity for banks in Europe,5 started experiencing significant tensions – for example, interbank loan spreads went significantly up, staying high until recently, and the European


3 For the current crisis, see Ivashina and Scharfstein (2009) for loans to large firms, and Puri, Rocholl and Steffen (2009) for loans to households.  4 In the current crisis, in fact, comprehensive surveys to banks on their lending standards and to firms on their access to finance suggest that credit demand was reduced, and also banks cut credit because their lack of capital and liquidity. The surveys suggest that the tightening of lending standards, in particular average loan rejections, have been stronger for smaller firms. For the Euro Area, see in particular the Survey on the Access to Finance of SMEs in the Euro Area (http://www.ecb.int/stats/money/surveys/sme/html/index.en.html) and the Euro Area Bank Lending Survey (http://www.ecb.int/stats/money/surveys/lend/html/index.en.html).  5 See for example Upper (2006). 

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crisis was an unexpected shock across all European countries and not related to the Portuguese banks. Moreover, the tensions in the European interbank market have continued until recently.

We have complete bank balance sheet data, including the interbank borrowing of each of the banks in the system, thus we can observe which banks were more affected by the interbank market tensions. In addition, we use an exhaustive dataset from the Portuguese central bank that has detailed loan level data on all corporate loans made by each bank in Portugal, including all the loans made to small and medium size firms. Finally, we have some balance sheet characteristics for the borrowers.

We exploit the interbank liquidity dependence (borrowing) for each bank before the crisis, which gives significant variation in bank liquidity shocks induced by the unexpected interbank crisis. It is important to notice that bank dependence to interbank funds before the crisis (2007:Q2) is not correlated with measures of bank profitability, risk or capital. Moreover, interbank liabilities in Portugal decreased significantly after the crisis started (9th of August 2007), and even more after the


6 On the 9th of August 2009, the ECB had to inject a significant amount of liquidity to banks due to a dry up in the interbank markets (see ECB Financial Stability Review, 2009). "The very significant stress in interbank markets first manifested itself in August 2007, the ECB immediately stepped into the breach and accommodated the temporarily elevated liquidity demand from the banks through a fixed rate operation with full allotment, providing €95 billion to the market within a few hours.

Overnight lending of the same kind continued to be provided albeit with lower volumes during the following three days. So we can say that the ECB was the first central bank in the turmoil to engage in non-standard measures." (Jean-Claude Trichet, April 2009, New York; see http://www.ecb.eu/press/key/date/2009/html/sp090427.en.html). Moreover, interbank spreads immediately raised significantly, in particular the spread between LIBOR 3 months and OIS 3 months increased over 50 basis points and stayed high or even significantly higher until very recently. The shock in general reduced cross-country bank linkages across Europe, not only for Portuguese banks. In particular: “The generalised market disruption has exerted a strong negative impact on the interbank money market, leading to segmentation along national borders” (page 9, ECB Financial Integration Report, April 2009)." 

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finance also went up significantly. Hence, the crisis created a liquidity shock for the banks that were borrowing more from the interbank market just before the onset of the crisis.

Since Portuguese banks had differential exposure to the interbank market before the shock, we can test whether the shock had a differential impact across banks that were more (less) exposed. We use a difference-in-difference approach comparing lending before and after the crisis among banks with different liquidity shocks (proxied by the interbank borrowing ratio before the onset of the crisis, specifically in May 2007). We control for observed and unobserved firm heterogeneity in loan demand, quality and risk by using firm fixed-effects.7 That is, for the same firm, we compare the change in lending by more and less affected banks before (2007:Q2) and after the crisis (2009:Q2). When a firm borrows from several banks simultaneously, the bank liquidity transmission mechanism predicts a larger drop in credit from banks that were more interbank dependent before the onset of the crisis.8 Furthermore, we examine whether banks cut back on lending differently across firms. Finally, we test the extent to which firms can substitute a drop in credit supply from an existing lender by accessing funds from other banks or, in general, from other sources of credit.

We find that, on average, a firm that borrows more from banks with a higher interbank borrowing ratio in 2007:Q2 experiences a greater reduction in credit during the crisis. One could be concerned that this effect could be driven by banks with higher interbank deposits on average lending more to firms with lower loan demand


7 See Khwaja and Mian (2008).  8 See for example Freixas and Rochet (2008) and Tirole (2006). 

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a borrower, we find that – for the same firm – the greater decline in credit comes from the bank with a higher ex-ante interbank borrowing ratio. This suggests that there is a contraction of supply of credit that stems from a dry up of liquidity in the interbank market – i.e., a crunch in (inter) bank liquidity implies a credit crunch for firms. In terms of economic magnitudes we find that a 10% increase in borrowing in the interbank markets prior to the crisis leads to a further 4% percent reduction in firm credit availability during the crisis.

Moreover, we find that interbank borrowing both from domestic or foreign banks has a very similar economic impact on credit availability. This provides additional support to the credit supply channel as international interbank borrowings in all of Europe dried up dramatically during the crisis (ECB Financial Integration Report, 2009) and, hence, it does not relate to conditions in Portuguese banks.9 We then examine whether the credit supply reduction was different across different category of firms. Controlling for firm fixed effects, we find that the magnitude of credit supply reduction due to the interbank liquidity exposure is significantly higher economically and statistically for firms that are a) smaller in size (as measured by total assets or number of employees), b) younger (as measured by the age of incorporation) c) with lower bank relationship (as measured by the firm-bank credit volume before the crisis). Moreover, for the large firms results are not statistically significant anymore. In fact the coefficient drops to zero in some


9 In fact, as Reinhardt and Rogoff (2009) document, Portugal is one of the very few developed countries without a banking crisis since the Second World War. Notice also that the Portuguese financial system is bank dominated. Portugal also did not have a bubble prior to the crisis; however, on the other hand, Portugal has a very low aggregate saving rate which implies that the need for external (international) finance is large. 

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only for entrepreneurial (smaller and younger) firms.

On firm characteristics that proxy for quality and risk such as firm return on assets and loan interest coverage, we find that banks cut credit supply across the board with respect to firm profits. However, surprisingly, we find that banks do not cut (in fact, support) credit supply to weaker firms in terms of low loan interest coverage. A possible explanation could be that reduction in credit to these firms might increase potential loan defaults which would in turn increase capital requirements for banks (see Caballero et al., 2008).

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