Corporate Finance and the Transmission of Shocks to the Real Economy
The transmission of credit supply or monetary policy shocks to the economy depends on frictions in different credit markets. For example, the degree to which a policy rate change affects firms’ funding costs depends on the substitutability of bond and bank financing as well as the substitutability of loans across different banks. Additionally, idiosyncratic productivity shocks may have an aggregate impact, depending on how firms can leverage up investment in more productive capital. This paper introduces a theoretical framework to study firms’ corporate finance choices and their implications for the transmission of shocks to the real economy. The model allows a firm to choose between self-financing or external debt funding through the bond market or bank loans.
- In the study’s sample, larger, more productive firms rely on more banks and more sources of funding, and smaller firms mostly rely on a small number of banks and internal funding.
- Although the overall share of bank funding decreases with firm size, the number of banking relationships increases.
- Firms with multiple banking relationships borrow larger shares from banks that offer lower interest rates.
- The cost of debt funding decreases with firm size.
- The results from the paper’s model show a bank credit supply shock, through a lack of substitutability among alternative credit sources, leads to a notable reduction in aggregate output that is marked by substantial heterogeneity across firms.
- Small firms are most affected by a credit supply shock, because they subsequently face substantially higher costs of funding and experience a resulting decline in output.
- The largest firms, many of which borrow from multiple banks in addition to the bond market, also face a reduction in output.
- The differential impact of a credit supply shock on firms implies that an increase in product market concentration could follow the shock as the sales shares of large firms increase.
The paper’s quantitative analysis shows how the impact of a bank credit supply shock can depend on firm size and what such a differential effect could mean for real economic activity and market concentration. The results also show that credit market frictions that prevent a perfect substitutability across funding sources are key for the transmission of financial shocks to aggregate output. These findings suggest that policies targeted at improving credit availability to firms, especially smaller ones, may be important for mitigating the adverse effect of bank credit supply shocks on output, especially when substitutability of bank credit may be low, such as during a crisis. The paper also has important implications for the empirical identification of credit supply shocks, showing that the state-of-the-art approach may lead to biased results when bank-firm matching prevails.