The Anatomy of a Credit Supply Shock

We examine how lending channel effects are transmitted by tracing the anatomy of a credit supply shock for small and medium sized business-lending in emerging markets. Using a novel data set that captures both lending relationships and a bank-wide shock for a multinational bank, we examine how lending channel effects vary by firm and loan contract characteristics. Borrowers with better ratings, borrowers that pledge firm non-specific collateral such as cash and property, and borrowers that yield higher non-lending revenues experience lower cuts in lending when there is a bank-wide credit supply shock. We show that the results are not explained by credit demand or borrowers with multiple relationships shifting borrowing away from the bank. Our results highlight the important role that collateral plays in financial contracts, not only at loan origination but also on an ongoing basis. In addition to increasing financing capacity through mitigating ex-ante and ex-post contracting problems, pledging collateral insulates firms from supply-side lending channel frictions which are unrelated to firm risk. The results also suggest that loan contracting, and in particular non-specific collateral, is a channel through which borrowers can mitigate bank-specific lending channel effects without turning to alternate lenders in the credit market. ∗Acknowledgements: We thank seminar participants at Tilburg University and Georgetown University for helpful discussions. The authors are from Kellstadt Graduate School of Business, DePaul University and Tilburg University (Liberti) and McDonough School of Business, Georgetown University (Sturgess). Bank liquidity or credit shocks were at the center of the recent financial crisis. Facing shocks to liquidity, banks passed on the fluctuations to borrowing firms even when there was no change in the borrrowers’ credit worthiness or demand for credit. These lending channel shocks can have large real effects if firms are unable to withstand fluctuations in credit supply. While the literature has examined aggregate lending channel effects (e.g., Kashyap et. al., 1993; Peek and Rosengren, 1997; Kashyap and Stein, 2000; Paravisini, 2007), very little is understood about the anatomy of these effects and the lending margins that determine the transmission of credit shocks. In this paper, we examine the anatomy of a bank-specific credit supply shock using a novel cross-country data set containing small and medium-sized business loans issued by a multinational bank to private firms in six emerging markets. This setting offers a unique opportunity to study how lending channel effects impact firms; and in turn how certain borrowers are better insulated from lending channel effects. Faced with a liquidity shock that shifts the supply curve inward we should observe a decrease in lending and an increase in the marginal price that banks charge lenders. The increase in marginal price may incorporate one of or a combination of a decrease in risk or an increase in lending income. In particular, cross-sectionally we study the role that risk, such as credit rating, firm size, and collateral, and income, such as spread lending and non-lending revenues, play in the transmission of the credit supply shock. The bank-specific credit supply shock we study provides a natural experiment to trace the impact of lending channel effects. Our data come from the small and medium-sized firm lending division of a large multinational bank that operates in emerging economies. The bank’s lending portfolio totals $2.46 billion at the start of 2004. In the first quarter of 2004, headquarters, which approves and allocates overall lending limits for each country, implemented an unanticipated worldwide 20% reduction in the approved amount of funds for all small and medium-sized business lending programs. Since the shock was unanticipated and imple-