Which Financial Frictions? Parsing the Evidence from the Financial Crisis of 2007 to 2009

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Previous articleNext article FreeWhich Financial Frictions? Parsing the Evidence from the Financial Crisis of 2007 to 2009Tobias Adrian, Paolo Colla, and Hyun Song ShinTobias AdrianFederal Reserve Bank of New York Search for more articles by this author , Paolo CollaBocconi University Search for more articles by this author , and Hyun Song ShinPrinceton University and NBER Search for more articles by this author Federal Reserve Bank of New YorkBocconi UniversityPrinceton University and NBERPDFPDF PLUSFull Text Add to favoritesDownload CitationTrack CitationsPermissionsReprints Share onFacebookTwitterLinked InRedditEmailQR Code SectionsMoreI. IntroductionThe financial crisis of 2007 to 2009 has given renewed impetus to the study of financial frictions and their impact on macroeconomic activity. Economists have refined existing models of financial frictions to construct narratives of the recent crisis. Although the recent innovations to the modeling of financial frictions share many common elements, they also differ along some key dimensions. These differences may not matter so much for story-telling exercises that focus on constructing logically consistent narratives that highlight particular aspects of the crisis. However, the differences begin to take on more significance when economists turn their attention to empirical or policy-related questions that bear on the costs of financial crises. Since policy questions must make judgments on the relative weight given to specific features of the models, the underpinnings of the models matter for the debates.A long-running debate in macroeconomics is whether financial frictions manifest themselves mainly through shocks to the demand for credit or to its supply. Frictions operating through shocks to demand may be the result of the deterioration of the creditworthiness of borrowers, perhaps through tightening collateral constraints or to declines in the net present value of the borrowers' projects. Shocks to supply arise from tighter lending criteria applied by the lender, especially by the banking sector. The outcome of this debate has consequences not only for the way that economists approach the theory but also for the conduct of financial regulation and macro stabilization policy.Our paper has two main objectives. The first is to revisit the debate on the demand and supply of credit to firms in the light of the evidence from the recent crisis. We argue that the evidence points overwhelmingly to a shock in the supply of intermediated credit by banks and other financial intermediaries. Firms that had access to direct credit through the bond market took advantage of their access and tapped the bond market in large quantities. For such firms, the decline in bank lending was largely made up through increased borrowing in the bond market. However, the cost of credit rose steeply, whether for direct or intermediated credit, suggesting that the demand curve for bond financing shifted out as a response to the inward shift in the bank credit supply curve. Our finding echoes the earlier study by Kashyap, Stein, and Wilcox (1993), who pointed to the importance of shocks to the supply of intermediated credit as a key driver of financial frictions.The evidence suggests a number of follow-up questions. Our second objective in this paper is to enumerate these questions and explore possible routes to answering them. What is so special about the banking sector? Why did the recent economic downturn affect the banking sector so differently from the bond investors? Kashyap, Stein, and Wilcox (1993) envisaged a specific shock to the banking sector through tighter reserve constraints coming from monetary policy tightening, thereby squeezing bank lending. However, the downturn from 2007 to 2009 was more widespread, hitting not only the banking sector but the broader economy. We still face the question of why the banking sector behaves in such a different way from the rest of the economy.If banks were simply a veil, and merely reflected the preferences of the depositors who provide funding to the banks for on-lending, then banks would be irrelevant for financial conditions. A challenge for any macro model with a banking sector is to explain how one dollar that goes through the banking system is different from one dollar that goes directly to borrowers from savers. Holding savers' wealth fixed, when the banking sector contracts in a deleveraging episode, money that used to flow to borrowers through the banking sector now flows to borrowers directly through the bond market. Thus, showing that the banking sector "matters" in a macro context entails showing that the relative size of the direct and intermediated finance in an economy matters for financial conditions.We begin in section II by laying out some aggregate evidence from the Flow of Funds and highlight the points of contact with the theoretical literature on financial frictions. In section III, we delve deeper into the micro evidence on firm-level financing decisions and find that it corroborates the evidence in the aggregate data. Based on the evidence, we draw up a checklist for a theory of financial frictions, and sketch a simple static model of direct and intermediated credit that attempts to address the checklist.Along the way, we review the theoretical literature in the light of the evidence. Although many of the recent modeling innovations bring us closer to addressing the full set of facts, there are a number of areas where modeling innovations are still needed. We hope that our paper may be a spur to further efforts at closing these gaps.II. PreliminariesA. Aggregate EvidenceMost models of financial frictions share the feature that the total quantity of credit to the nonfinancial corporate sector decreases in a downturn, whether it is due to a decline in the demand for credit or its supply. However, even this basic proposition needs some qualification when we examine the evidence in any detail.Figure 1 shows the total credit to the US nonfinancial noncorporate business sector from 1990 (both farm and nonfarm). Mortgages of various types figure prominently in the composition of total credit and suggest that the availability of collateral is an important determinant of credit to the noncorporate business sector. The trough in total credit comes in the second quarter of 2011, and the peak to trough (Q4:2008 to Q2:2011) decline in total credit is roughly 8 percent.Fig. 1. Credit to US nonfinancial noncorporate businessesSource: US Flow of Funds, tables L103, L104.View Large ImageDownload PowerPointFigure 2 examines the evolution of credit to the corporate business sector in the United States (the nonfarm, nonfinancial corporate business sector). The left-hand panel is in levels, taken from table L.102 of the US Flow of Funds, while the right-hand panel plots the quarterly changes, taken from table F.102 of the Flow of Funds.Fig. 2. Credit to US nonfi nancial corporate sector (left-hand panel) and changes in outstanding corporate bonds and loans to US nonfi nancial corporate sector (right-hand panel)Notes: The left panel is from US Flow of Funds, table L102. Right panel is from table F102. Loans in right panel are defi ned as sum of mortgages, bank loans not elsewhere classifi ed (n.e.c.), and other loans.View Large ImageDownload PowerPointThe plots reveal some distinctive divergent patterns in the various components of credit. In the left hand panel, the lower three components are (broadly speaking) credit that is provided by banks and other intermediaries, while the top series is the total credit obtained in the form of corporate bonds. The narrow strip between the bond and bank financing is the amount of commercial paper.While the loan series show the typical procyclical pattern of rising during the boom and then contracting sharply in the downturn, bond financing behaves very differently. On the right-hand panel, we see that bond financing surges during the crisis period, making up most of the lost credit due to the contraction of loans.The substitution away from intermediated credit toward the bond market is reminiscent of the finding in Kashyap, Stein, and Wilcox (1993), who documented that firms reacted to a tightening of credit by banks by issuing commercial paper. While commercial paper plays a relatively small role in the total quantity of credit in figure 2, the principle that firms switch to alternatives to bank financing is very much in evidence.Nevertheless, the aggregate nature of the data from the Flow of Funds means that some caution is needed in drawing any firm conclusions. Several questions spring to mind. First, the Flow of Funds data are snapshots of the total amounts outstanding, rather than actual flows associated with new credit. Ideally, the evidence should be on the flow of new credit.Second, to tell us whether the shock is demand- or supply-driven, information on the price of the new credit is crucial, but the Flow of Funds is silent on prices. A demand-driven fall in credit would exert less upward pressure on rates than a supply-driven shock. A simultaneous analysis of quantities and prices may enable to disentangle shocks to demand from shocks to supply.Third, the aggregate nature of the Flow of Funds data masks differences in the composition of firms, both over time and in cross-section. The variation over time may simply reflect changes in the number of firms operating in the market. In cross-section, we should take account of corporate financing decisions (loan versus bond financing) that are related to firm characteristics.To address these justified concerns, we construct a micro-level data set on new loans and bonds issued by nonfinancial US corporations between 1998 and 2010. Our data set includes information about quantities and prices of new credit, which give us insights on whether the quantity changes are due to demand or supply shocks. Second, our data set contains information on firm characteristics (asset size, Tobin's Q, tangibility, ratings, profitability, leverage, etc.) that previous studies have identified as drivers of the mix of loan and bond financing. The cross-section information gives us another perspective on how credit supply affects firms' corporate choices since we can control for demand-side proxies. Finally, we make use of the reported purpose of loan and bond issuances to single out new credit for "real investment"—that is, general corporate purposes, including capital expenditure, and liquidity management—which allows us to focus on corporate real activities (see Ivashina and Scharfstein 2010). By doing so, we exclude new debt that is issued for acquisitions (acquisition, takeover, and leveraged buyout/management buyout, LBO/MBO); capital structure management (debt repayment, recapitalization, and stock repurchase); as well as credit lines used as commercial paper backup.We examine new issuances across all firms in our sample and ask whether the features we observe in the aggregate also hold at the micro level. We find that they do. During the economic downturn of 2007 to 2009, the total amount of new issuances decreased by 50 percent. When we look at loans and bonds separately, we uncover a 75 percent decrease in loans but a twofold increase in bonds. However, the cost of both types of financing show a steep increase (fourfold increase for new loans, and threefold increase for bonds). We take this as evidence of an increase in demand of bond financing and a simultaneous contraction in banks' supply of loan financing.To shed further light on firm-level substitution between loan and bond financing, we conduct further disaggregated tests to be detailed later. Our tests are for firms that have access to the bond market—proxied by being rated—so that we can allow the demand and supply factors to play out in the open. We find that loan amounts decline but bond amounts increase, leaving total financing unchanged, while the cost of both loan and bond financing increases. Thus, the evidence points to a contraction in the supply of bank credit that pushes firms into the bond market, which raises the price of both types of credit. The micro evidence therefore corroborates the aggregate evidence from the Flow of Funds. We conclude that the decline in the supply of bank financing trains the spotlight on those firms that do not have access to the bond market (such as the noncorporate businesses in figure 1). It would be reasonable to conjecture that financial conditions tightened sharply for such firms.To understand the substitution between loan and bond financing better, we follow Denis and Mihov (2003) and Becker and Ivashina (2011) to examine the choice of bond versus loan issuance in a discrete choice framework. Becker and Ivashina (2011) find evidence of substitution from loans to bonds during times of tight monetary policy, tight lending standards, high levels of nonperforming loans, and low bank equity prices. Controlling for demand factors, we find that the 2007 to 2009 crisis reduced the probability of obtaining a loan by 14 percent. We further corroborate the evidence in Becker and Ivashina (2011) by using two proxies for the financial sector risk-bearing capacity (for the growth in broker-dealer leverage, see Adrian, Moench, and Shin 2011; for the excess bond premium, see Gilchrist and Zakrajšek 2011) and document that a contraction in intermediaries' risk-bearing capacity reduces the probability of loan issuance between 18 and 24 percent depending on the proxy employed. Finally, we investigate which firm characteristics insulate borrowers from the effect of bank credit supply shocks in the 2007 to 2009 crisis. Our analysis highlights that firms that are larger or have more tangible assets, higher credit ratings, better project quality, less growth opportunities, and lower leverage were better equipped to withstand the contraction of bank credit during the crisis.B. Modeling Financial FrictionsThe evidence gives insights on how we should approach modeling financial frictions if we are to capture the observed features. Perhaps the three best-known workhorse models of financial frictions used in macroeconomics are Bernanke and Gertler (1989), Kiyotaki and Moore (1997), and Holmström and Tirole (1997). However, in the benchmark versions of these models, the lending sector is competitive and the focus of the attention is on the borrower's net worth instead. The results from the benchmark versions of these models should be contrasted with the approach that places the borrowing constraints on the lender (i.e., the bank) as in Gertler and Kiyotaki (2010).Bernanke and Gertler (1989) use the costly state verification (CSV) approach to derive the feature that the borrower's net worth determines the cost of outside financing. The collateral constraint in Kiyotaki and Moore (1997) introduces a similar role for the borrower's net worth through the market value of collateral assets whereby an increase in borrower net worth due to an increase in collateral value serves to increase borrower debt capacity. But in both cases, the lenders are treated as being competitive and no meaningful comparisons are possible between bank and bond financing. In contrast, the evidence from figure 2 points to the importance of understanding the heterogeneity across lenders and the composition of credit. The role of the banking sector in the cyclical variation of credit emerges as being particularly important.A bank is simultaneously both a borrower and a lender—it borrows in order to lend. As such, when the bank itself becomes creditconstrained, the supply of credit to the ultimate end-users of credit (nonfinancial businesses and households) will be impaired. In the version of the Holmström and Tirole (1997) model with banks, credit can flow either directly from savers to borrowers or indirectly through the banking sector. The ultimate borrowers face a borrowing constraint due to moral hazard, and must have a large enough equity stake in the project to receive funding. Banks also face a borrowing constraint imposed by depositors, but banks have the useful purpose of mitigating the moral hazard of ultimate borrowers through their monitoring. In Holmström and Tirole (1997), the greater monitoring capacity of banks eases the credit constraint for borrowers who would otherwise be shut out of the credit market altogether. Firms follow a pecking order of financing choices where low net worth firms can only obtain financing from banks and are shut out of the bond market, while firms with high net worth have access to both, but use the cheaper bond financing.Repullo and Suarez's (2000) model is in a similar spirit. Bolton and Freixas (2000) focus instead on the greater flexibility of bank credit in the face of shocks, as discussed by Berlin and Mester (1992), with the implication that firms with higher default probability favor bank finance relative to bonds. De Fiore and Uhlig (2011, 2012) explore the implications of the greater adaptability of bank financing to informational shocks in the spirit of Berlin and Mester (1992) and examine the shift toward greater reliance on bond financing in the Eurozone during the recent crisis.Our empirical results reported in the following suggest that the interaction between direct and intermediated finance should be high on the agenda for researchers. We review the new theoretical literature on banking and intermediation in a later section.C. Focus on Banking SectorWe are still left with a broader theoretical question of what makes the banking sector so special. In Kashyap, Stein, and Wilcox (1993), the shock envisaged was a monetary tightening that hit the banking sector specifically through tighter reserve requirements that led to a shrinking of bank balance sheets. However, the downturn in 2007 to 2009 was more widespread, hitting not only the banking sector but the broader economy.A clue lies in the way that banks manage their balance sheets. Figure 3 is the scatter plot of the quarterly change in total assets of the sector consisting of the five US investment banks examined in Adrian and Shin (2008, 2010) where we plot both the changes in assets against equity, as well as changes in assets against debt. More precisely, it plots {(ΔAt, ΔEt)} and {(ΔAt, ΔDt)} where ΔAt is the change in total assets of the investment bank sector at quarter t, and where ΔEt and ΔDt are the change in equity and change in debt of the sector, respectively.Fig. 3. Scatter chart of {(ΔAt, ΔEt)} and {(ΔAt, ΔDt)} for changes in assets, equity, and debt of US investment bank sector consisting of Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley between Q1:1994 and Q2:2011Source: Securities and Exchange Commission (SEC) 10Q filings.View Large ImageDownload PowerPointThe fitted line through {(ΔAt, ΔDt)} has slope very close to 1, meaning that the change in assets in any one quarter is almost all accounted for by the change in debt, while equity is virtually unchanged. The slope of the fitted line through the points {(ΔAt, ΔEt)} is close to zero.1Commercial banks show a similar pattern to investment banks. Figure 4 is the analogous scatter plot of the quarterly change in total assets of the US commercial bank sector, which plots {(ΔAt, ΔEt)} and {(ΔAt, ΔDt)} using the FDIC Call Reports. The sample period is between Q1:1984 and Q2:2010. We see essentially the same pattern as for investment banks, where every dollar of new assets is matched by a dollar in debt, with equity remaining virtually unchanged. Although we do not show here the scatter charts for individual banks, the charts for individual banks reveal the same pattern. Banks adjust their assets dollar for dollar through a change in debt with equity remaining "sticky."Fig. 4. Scatter chart of {(ΔAt, ΔEt)} and {(ΔAt, ΔDt)} for changes in assets, equity, and debt of US commercial bank sector at t between Q1:1984 and Q2:2010Source: FDIC call reports.View Large ImageDownload PowerPointThe fact that banks tend to reduce debt during downturns could be explained by standard theories of debt overhang or adverse selection in equity issuance. However, what is notable in figures 3 and 4 is the fact that banks do not issue equity even when assets are increasing. The fitted line through the debt issuance curve holds just as well when assets are increasing as it does when assets are decreasing. This feature presents challenges to an approach where the bank capital constraint binds only in downturns, or to models where the banking sector is a portfolio maximizer.Figures 3 and 4 show that banks' equity is little changed from one quarter to the next, implying that total lending is closely mirrored by the bank's leverage decision. Bank lending expands when its leverage increases, while a sharp reduction in leverage ("deleveraging") results in a sharp contraction of lending. Adrian and Shin (2008, 2010) showed that US investment banks have procyclical leverage where leverage and total assets are positively related.Figure 5 is the scatter chart of quarterly asset growth and quarterly leverage growth for US commercial banks for the period Q1:1984 to Q2:2010. We see that leverage is procyclical for US commercial banks also. However, we see that the sharp deleveraging in the recent crisis happened comparatively late, with the sharpest decline in assets and leverage taking place in Q1:2009. Even up to the end of 2008, assets and leverage were increasing, possibly reflecting the drawing down of credit lines that had been granted to borrowers prior to the crisis.Fig. 5. Scatter chart of quarterly asset growth and quarterly leverage growth of the US commercial bank sector, Q1:1984 to Q2:2010Source: FDIC Call Reports.View Large ImageDownload PowerPointThe equity series in the scatter charts in figures 3, 4, and 5 are of book equity, giving us the difference between the value of the bank's portfolio of claims and its liabilities. An alternative measure of equity would have been the bank's market capitalization, which gives the market price of its traded shares. Since our interest is in the supply of credit, which has to do with the portfolio decision of the banks, book equity is the appropriate notion. Market capitalization would have been more appropriate if we were interested in new share issuance or mergers and acquisitions decisions.Crucially, it should be borne in mind that market capitalization is not the same thing as the marked-to-market value of the book equity, which is the difference between the market value of the bank's portfolio of claims and the market value of its liabilities. Take the example of a securities firm holding only marketable securities that finances those securities with repurchase agreements. Then, the book equity of the securities firm reflects the haircut on the repos, and the haircut will have to be financed with the firm's own book equity. This book equity is the archetypal example of the marked-to-market value of book equity.In contrast, market capitalization is the discounted value of the future free cash flows of the securities firm, and will depend on cash flows such as fee income, which do not depend directly on the portfolio held by the bank.Since we are interested in lending decisions of intermediaries, it is the portfolio choice of the banks that is our main concern. As such, book value of equity is the appropriate concept when mea