The Financial Sector and the Real Economy During the Financial Crisis: Evidence from the Commercial Paper Market

Abstract

Shocks to the financial sector led credit spreads to widen to unprecedented levels in many markets during the 2007-2008 financial crisis. The rise in spreads attracted attention because it could signal a disruption in financial markets, which has been widely linked to an increased burden on non-financial firms. This paper disentangles the relative contributions of credit and liquidity risk in explaining the widening of commercial paper spreads. In doing so, we find that liquidity risk was isolated to the financial sector throughout the first two major shocks to the system (August 2007 and March 2008). Indeed, controlling for credit risk, non-financial corporations saw little or no change in the cost of funding during this time period. After the bankruptcy of Lehman Brothers, for the first time, liquidity problems in the commercial paper market spilled out of the financial sector into the spreads of low credit quality non-financial firms. This effect had a disproportionately larger impact on those low credit-quality non-financial firms that placed paper exclusively through financial sector dealers. High credit quality firms remained unaffected throughout. Our interpretation of the results is that markets were able to differentiate not only between safe and imperiled firms in the midst of the crisis, but also to isolate where liquidity effects were most likely to be salient.