Collateral , Debt Capacity , and Corporate Investment : Evidence from a Natural Experiment

This paper examines how a shock to collateral value, caused by asset market fluctuations, influences the debt capacities and investments of firms. Using a source of exogenous variation in collateral value provided by the land market collapse in Japan, I find a large impact of collateral on the corporate investments of a large sample of manufacturing firms. For every 10 percent drop in collateral value, the investment rate of an average firm is reduced by 0.8 percentage point. Further, exploiting a unique data set of matched bank-firm lending, I provide direct evidence on the mechanism by which collateral affects investment. In particular, I show that collateral losses results in lower debt capacities: firms with greater collateral losses are less likely to sustain their banking relationships and, conditional on lending being renewed, they obtain a smaller amount of bank credit. Moreover, the collateral channel is independent of the contemporaneous influence of worsened bank financial conditions. ∗I thank Tim Adam, Kalok Chan, Sudipto Dasgupta, Vidhan Goyal, Yasushi Hamao, Takeo Hoshi, Christopher James, Wei Jiang, Stewert Myers, Raghu Rajan, David Scharfstein, Sheridan Titman, William Wheaton, Takeshi Yamada, and seminar participants at MIT, the NBER Summer Institute, the HKUST Finance Symposium, and the Western Finance Association meeting for their comments and suggestions. I am particularly grateful to the anonymous referee whose insightful and constructive comments have substantially improved the paper. I also thank Yoshiaki Ogura and Carol Tse for excellent research assistance and the Center on Japanese Economy and Business at the Columbia Business School for a faculty research grant. †Department of Finance, School of Business and Management, Hong Kong University of Science and Technology, Clear Water Bay, Kowloon, Hong Kong. Email: jgan@ust.hk; Tel: 852 2358 7665; Fax: 852 2358 1749. Collateral, Debt Capacity, and Corporate Investment: Evidence from a Natural Experiment Abstract This paper examines how a shock to collateral value, caused by asset market fluctuations, influences the debt capacities and investments of firms. Using a source of exogenous variation in collateral value provided by the land market collapse in Japan, I find a large impact of collateral on the corporate investments of a large sample of manufacturing firms. For every 10 percent drop in collateral value, the investment rate of an average firm is reduced by 0.8 percentage point. Further, exploiting a unique data set of matched bank-firm lending, I provide direct evidence on the mechanism by which collateral affects investment. In particular, I show that collateral losses results in lower debt capacities: firms with greater collateral losses are less likely to sustain their banking relationships and, conditional on lending being renewed, they obtain a smaller amount of bank credit. Moreover, the collateral channel is independent of the contemporaneous influence of worsened bank financial conditions.This paper examines how a shock to collateral value, caused by asset market fluctuations, influences the debt capacities and investments of firms. Using a source of exogenous variation in collateral value provided by the land market collapse in Japan, I find a large impact of collateral on the corporate investments of a large sample of manufacturing firms. For every 10 percent drop in collateral value, the investment rate of an average firm is reduced by 0.8 percentage point. Further, exploiting a unique data set of matched bank-firm lending, I provide direct evidence on the mechanism by which collateral affects investment. In particular, I show that collateral losses results in lower debt capacities: firms with greater collateral losses are less likely to sustain their banking relationships and, conditional on lending being renewed, they obtain a smaller amount of bank credit. Moreover, the collateral channel is independent of the contemporaneous influence of worsened bank financial conditions.