Sorting Out the Real Effect of Credit Supply

Abstract

We document that banks that cut lending more during the Great Recession were lending to
riskier firms ex-ante. To understand the aggregate implications of this sorting pattern, we
build an assignment model in which banks have heterogeneous costs to take on risky loans and
firms have different credit risks. In the model, aggregate loan volume depends on the entire
distribution of bank holding costs and firm credit risks. We then use our model to recover the
change in the distribution of bank holding costs during the Great Recession and quantify its
effect on aggregate loan volume.

Keywords: Credit supply, Financial Crises, Matching Model, Credit Risk

JEL Classification: G01, G21, G2, G23