The Good, the Bad, and the not-so Ugly of Credit Booms: Capital Allocation and Financial Constraints

Abstract

We provide international empirical evidence that periods of rapid expansion in credit—credit booms—lead to a tradeoff between a relaxation of financial constraints and a worsening of capital allocation. This tradeoff is stronger across small, financially constrained, and more innovative firms, as well as for firms in less tangible and more opaque industries. While the misallocation effect is similar for firms located in countries with different levels of income and financial development, firms in poorer and less financially developed countries enjoy a greater relaxation of financial constraints. Credit booms with higher capital misallocation are associated with a higher probability of experiencing a banking crisis and with poor economic and financial performance after the boom.

Keywords: Credit Boom, Capital Allocation, Financially Constrained Firms

JEL Classification: G32, G15, F44