Balance Sheet Strength and Bank Lending During the Global Financial Crisis

Abstract

We examine the role of bank balance sheet strength in the transmission of financial sector shocks to the real economy. In particular, we exploit variation in banks’ wholesale funding reliance and their capital levels in 2007Q2 to estimate the impact of bank liquidity shocks in 2007-2008 on the supply of large corporate loans and real economic outcomes. We find that banks with ex-ante stronger balance sheets were better able to maintain lending during the global financial crisis. Banks that were more dependent on market funding reduced the supply of credit more than other banks during the crisis but higher levels of better-quality capital mitigated this effect. Reduced credit supply translated into lower economic activity for firms borrowing from thinly-capitalized banks, suggesting there was limited scope for credit substitution across lenders or debt markets. These findings indicate that strong financial intermediary balance sheets are key for the recovery of credit and economic performance after large financial sector shocks. They also support regulatory steps to boost high-quality capital buffers under the Basel III framework.