Do Bank-Credit Constraints Affect the Cost of Equity?

Abstract

Theories of bank credit policy predict that banks coordinate to tighten credit policy when borrowers in a sector experience an adverse shock, and this induces credit constraints in all sectors. When multiple banks lend to the sector the market can learn about the systematic component of the shock, even if the market does not observe the shock. Because banks possess inside information, investors interpret contractions in credit supply as a signal about the true state of the economy and include information on credit contractions in their information set when pricing systematic risks. Using a conditional asset pricing model, I find that after augmenting investors' information set with a measure of bank-credit contractions, average total absolute risk premium for small and large firms increase by 13 and 7 percentage points, respectively, and that for the market portfolio increases by more than 10 points. Information about credit contractions is most influential in pricing market and exchange rate risks. Further evidence suggests that most of the impact of credit contractions is not attributable to tight monetary policy. These results are robust to a battery of diagnostic tests, alternative proxies for credit contractions, information sets, and size-based portfolios, and hold over different sub-periods.