Sorting Out the Real Effects of Credit Supply

Abstract

We document that banks which cut lending the most during the Great Recession were lending to the riskiest firms. Motivated by this evidence, we build a competitive matching model of bank-firm relationship, in which firms with riskier projects borrow from the banks with lower holding costs (e.g. higher ability to securitize). A firm's ability to borrow depends on the entire distribution of bank holding cost. We derive and estimate a simple measure of this distribution using loan rate and credit ratings data. We conclude that its upward shift during the Great Recession, i.e. credit supply effect, explains the decline in aggregate firm loans as opposed to an increase in firm riskiness.

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

JEL Classification: G01, G21, G2, G23