The Effect of State Solvency on Bank Values and Credit Supply: Evidence from State Pension Cut Legislation
Lee J. Cohen
University of Georgia - Department of Finance
Marcia Millon Cornett
Bentley University - Department of Finance
Federal Reserve Bank of New York
Boston College - Department of Finance
April 14, 2015
This study uses different outcomes of state pension cut legislation to examine connections between state solvency, bank values, and credit supply. As Wisconsin and Ohio moved through their legislative processes, we find banks with operations more heavily concentrated in Wisconsin and Ohio experience positive (negative) stock price reactions to announcements that indicate an increased (a decreased) probability of pension cut legislation. We find these states’ municipal bond spreads also tighten abnormally in response to higher expectations of pension cut legislation enactment. Over longer horizons, bank lending increases in Wisconsin in sharp contrast to Ohio where pension cut legislation was ultimately overturned. The contrasting changes in lending activity are largely explained by the municipal bond holdings of banks in each state. Last, we find the increased lending activity in Wisconsin comes from bank portfolios initially constrained by lower capital reserves, suggesting municipal bond revaluations free-up credit supply in more capital-constrained banks. Consistent with bank lending occurring through increased credit supply, rather than demand associated with broader changes in economic conditions, we find no evidence that industrial firms headquartered in the two states are affected by pension cut legislation. Overall, the findings suggest states’ budget cuts affect bank values and credit supply through their municipal bond holdings.
Number of Pages in PDF File: 56
Keywords: Credit supply, financial institutions, bank intermediation, municipal debt, public pensions
JEL Classification: G11, G21, G28, H72, H74, H75
Date posted: October 10, 2012 ; Last revised: April 15, 2015
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