Sorting Out the Real Effects of Credit Supply

Abstract

We show that banks that cut lending more during the Great Recession lent to riskier firms. To examine the equilibrium effect of this sorting pattern, we build an assignment model in which banks have heterogeneous holding costs and firms have heterogeneous risks. In the model, loan volume declines more when negative credit supply shocks are concentrated on low holding cost banks like Lehman Brothers relative to high holding cost banks. 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