Credit Market Frictions Research Articles

Financial Crises, Financial Constraints, and Government Guarantees

In this paper I ask whether and how government intervention in credit markets can help to ease financial constraints and encourage growth for small firms during financial crises. I focus my analysis on the presence of banks who take part in the Small Business Administration (SBA) 7(a) guaranteed lending program in a local market, and ask whether access to government-backed loans encouraged lending to small firms during the recent financial crisis when they were particularly constrained. I find that areas with a greater proportion of SBA guaranteed lenders saw a greater volume of small business loans during the crisis, and these areas experienced better real outcomes in terms of employment and establishments, especially for the smallest firms. This result is robust to controlling for a host of concurrent demand and supply characteristics, using alternative definitions of SBA market presence, and controlling for endogeneity through instrumental variables. This paper contributes to the literature examining access to finance and growth and the role of government intervention during crises. The findings suggest that targeted government support to small firms can play a beneficial role in the recovery of local regions in the presence of private credit market frictions.

Creditor protection laws, debt financing, and corporate investment over the business cycle

We examine how legal creditor rights are related to debt financing and corporate investment over the business cycle. Using firm-level data from 40 countries, we find that creditor rights are associated with greater debt financing and investment during economic downturns, but creditor rights have a significantly smaller effect during expansions. The beneficial effects of creditor rights during recessions are stronger for firms that are more likely to have severe shareholder–bondholder agency problems. We also find that during recessions (relative to expansions) strong creditor rights are associated with a smaller decline in net capital flows. Our findings are consistent with credit market frictions increasing during recessions, and with stronger creditor rights decreasing the negative effects of these frictions. Overall, the results suggest that better creditor protection laws help moderate the decline in debt financing and investment during recessions.

Disentangling goods, labor, and credit market frictions in three European economies

We build a flexible model with search frictions in three markets: credit, labor, and goods markets. We then apply this model (called CLG) to three different economies: a flexible, finance-driven economy (the UK), an economy with wage moderation (Germany), and an economy with structural rigidities (Spain). In these three countries, goods and credit market frictions play a dominant role in entry costs and account for 75% to 85% of the total entry costs. In the goods market, adverse supply shocks are amplified through their propagation to the demand side, as they also imply income losses for consumers. This adds up to, at most, an additional 15% to 25% to the impact of the shocks. Finally, the speed of matching in the goods market and the credit market accounts for a small fraction of unemployment: most variation in unemployment comes from the speed of matching in the labor market.

Creditor Rights, Agency Costs, and Business Cycles

We examine how legal creditor rights are related to debt financing and corporate investment over the business cycle. Using firm-level data from 40 countries, we find that creditor rights are associated with greater debt financing and investment during economic downturns, but creditor rights have a significantly smaller effect during expansions. The beneficial effects of creditor rights during recessions are stronger for firms that are more likely to have severe shareholder-bondholder agency problems. We also find that during recessions (relative to expansions) strong creditor rights are associated with a smaller decline in net capital flows. Our findings are consistent with credit market frictions increasing during recessions, and with stronger creditor rights decreasing the negative effects of these frictions. Overall, the results suggest that better creditor protection laws help moderate the decline in debt financing and investment during recessions.

Credit market frictions and political failure

We study how an excessively favorable regulatory environment for banks could arise even with a perfectly competitive credit market in a median voter world. In our occupational choice model with heterogeneous wealth endowments, market failure due to unobservability of entrepreneurial talent endogenously creates a misalignment between surplus maximizing reforms and reforms that are preferred by the median voter, who is a worker. This is in contrast to the world without market failure where the electorate unanimously vote in favor of surplus maximizing institutional reforms. This paper illustrates how market failure could lead to political failure even in the benchmark political system that is free from capture by interest groups.

Comment on “Credit market frictions and political failure” by Aney, Ghatak and Morelli

Comment on “Credit market frictions and political failure” by Aney, Ghatak and Morelli

Macropudential Policy in a Knightian Uncertainty Model with Credit-, Risk-, and Leverage Cycles

We study the impact of uncertainty on financial stability and the business cycle. We extend the work of Boz and Mendoza (2014) by endogenizing credit production, modifying learning mechanism into an adaptive set-up, as well as including financial and monetary policies. In our model households are (intrinsically) rational but take economic decisions under incomplete information. The incompleteness is not caused by their cognitive limitations, as in rational inattention theory (Sims, 2003). Households `learn by doing' and once a sufficient number of realizations of the state variable have materialized, and the incomplete information set is completed. This learning set-up is incorporated into a New Keynesian model with credit market frictions, extended to include uncertainty, where a share of households needs external financing to consume. Because of limited enforceability of financial contracts, households are required to provide collateral for their loans, and so the relationship between the bank and household is tightened for many periods ahead. We find in our framework the build up of risk, leverage, increase in consumption and price of collateral takes longer than in other DSGEs with standard financial friction models. We also find that both the frequency and the amplitude of expansions and contractions are asymmetric - recessions are less frequent and deeper than expansions. Moreover, we find that boom-bust cycles occur as rare events. Using the Cogley and Sargant's (2008) definition of a severe(or systemic) crisis, we find on average two such events per century. We also find that, different from standard boom-bust cycles, a systemic crisis can be followed by a sequence of subsequent contractions, as it makes the economy more unstable. The result is asymmetric distributions of key macroeconomic and financial variables, with high skewness and fat tails. Lastly, we also find that, by reducing the amount of borrowing and leverage in upturns, the LTV-ratio regulation is effective in smoothing the cycles and reducing the effects of a deep contraction on the real-financial variables. We also discuss the role of macroprudential policy in reducing information incompleteness by generating information that helps the agent learn faster the new environment, or provide a smoother transition to the new economic environment.

Optimal Progressivity of Redistribution with Frictions to Knowledge Diffusion

Benabou (2002) strengthens the so-called Efficient Redistribution Hypothesis (ERH) by demonstrating how income redistribution can promote growth and welfare by mitigating economic waste from resource misallocation that is caused by credit market frictions to production, which is subject to diminishing returns. We ask how the presence of knowledge externality in private education technology and social frictions resisting knowledge diffusion changes the optimal progressivity. In the model, the distribution of human capital of the parent's generation determines the stock of nonrival knowledge through a process of diffusion which is subject to communication frictions. The output cost of inequality and the optimal progressivity increase with the degree of knowledge externality and hence with social returns to education, if and only if, frictions to diffusion outweigh frictions to production. If the inequality augmenting neighborhood effect of parental human capital is relatively large, compared to the inequality mitigating impact of the economy's stock of nonrival knowledge, then the ERH fails with low communication frictions. However, if frictions and social returns to education are large, irrespective of its local or global origin, then even with endogenous growth led by constant returns to capital, the ERH survives.

Taxation, credit constraints and the informal economy

Abstract This paper extends Evans and Jovanovic (1989)'s entrepreneurship model to incorporate the informal sector. Specifically, entrepreneurs can operate either in the formal sector – in which they have limited access to credit markets and must pay taxes – or in the informal sector – in which they can avoid paying taxes, but have no access to credit markets. In addition, technology in the informal sector is both less productive and more labor intensive than that in the formal sector. We calibrate the model to the Brazilian economy, and evaluate the impact of credit frictions and taxation on occupational choices, aggregate output and inequality. Removing all distortions can improve aggregate efficiency considerably, largely because this induces entrepreneurs to switch to the formal sector, where the technology is superior. Most of this effect comes from removing credit market frictions, but taxes on formal businesses are also important. The elimination of distortions can also reduce income inequality substantially.

Disentangling goods, labor, and credit market frictions in three European economies

We build a flexible model with search frictions in three markets: credit, labor, and goods markets. We then apply this model (called CLG) to three different economies: a flexible, finance-driven economy (the UK), an economy with wage moderation (Germany), and an economy with structural rigidities (Spain). In the three countries, goods and credit market frictions play a dominant role in entry costs and account for 75% to 85% of total entry costs. In the goods market, adverse supply shocks are amplified through their propagation to the demand side, as they also imply income losses for consumers. This adds up to, at most, an additional 15% to 25% to the impact of the shocks. Finally, the speed of matching in the goods market and the credit market accounts for a small fraction of unemployment: Most of the variation in unemployment comes from the speed of matching in the labor market.

What inventory behavior tells us about how business cycles have changed

Beginning in the mid-1980s, U.S. business cycles changed in important ways, notably via distinctive shifts in the comovement and relative volatilities of labor productivity, hours, output, and inventories. Inventories provide additional information relative to aggregate investment regarding firms׳ intertemporal decisions, and thus additional insight in explaining business cycles. We show that variations in the discount factor estimated using inventories, which may be interpreted as fluctuations in a generalized investment wedge, play a key role in explaining the shifts in U.S. business cycles observed after the mid-1980s. Moreover, these variations correlate well with independent measures of credit market frictions.

Public debt and total factor productivity

This paper explores the role of public debt and fiscal deficits on factor productivity in an economy with credit market frictions and heterogeneous firms. When credit market conditions are sufficiently weak, low interest rates permit the government to run Ponzi schemes so that permanent primary deficits can be sustained. For small enough deficit ratios, the model has two steady states of which one is an unstable bubble and the other one is stable. The stable equilibrium features higher levels of credit and capital, but also a lower interest rate, lower total factor productivity and output. The model is calibrated to the US economy to derive the maximum sustainable deficit ratio and to examine the dynamic responses to changes in debt policy. A reduction in the primary deficit triggers an expansion of credit and capital, but it also leads to a deterioration of total factor productivity since more low-productivity firms prefer to remain active at the lower equilibrium interest rate.

Small DSGE Model with Financial Frictions

In the last few years, macroeconomic modelling has emphasised the role of credit market frictions in magnifying and transmitting nominal and real disturbances and their implication for macro-prudential policy design. In this paper, we construct a modest New Keynesian general equilibrium model with active banking sector. In this set-up, the financial sector interacts with the real side of the economy via firm balance sheet and bank capital conditions and their impact on investment and production decisions. We rely on the financial accelerator mechanism due to Bernanke et al. (1999) and combine it with a bank capital channel as demonstrated by Aguiar and Drumond (2007). We calibrate the resulting model from the perspective of a low income economy reflecting the existence of relatively high investment adjustment cost, strong fiscal dominance, and underdeveloped financial and capital markets where the central bank uses money growth in stabilizing the national economy. Then we examine the impulse response of selected endogenous variables to shocks stemming from the fiscal authority, the monetary policy process, and technological progress. The findings are broadly consistent with previous studies that demonstrated stronger role for credit market imperfections in amplifying and propagating monetary policy shocks. Moreover, we also compare the trajectory of the model economy under alternative monetary policy instruments. The results suggest that the model with money growth rule generates higher volatility in output and inflation than the one with interest rate rule.

Macroeconomic dynamics in a model of goods, labor, and credit market frictions

Goods market frictions drastically change the dynamics of the labor market, both in terms of persistence and volatility. In a model with three imperfect markets – goods, labor, and credit – we find that credit and goods market imperfections are substitutable in raising volatility. Goods market frictions are unique in generating persistence. Two key mechanisms in the goods market generate large hump-shaped responses to productivity shocks: countercyclical goods market tightness and prices alter future profit flows and raise persistence; procyclical search effort of consumers and firms raises amplification. Goods market frictions are thus key in understanding labor market dynamics.

Monetary policy and financial stability: what role for the interest rate?

We propose an ex-post analysis of the behavior of a central bank confronted with financial turmoil. For this purpose, we rely on a DSGE model that combines credit market frictions with a boom and bust scenario on the price of capital. Within this framework, we seek to understand the extent to which central banks could have intervened to limit the effects of the financial bubble and its bursting. We compare the results obtained in terms of economic stabilization under a simple Taylor rule with those of an augmented rule that takes into account a financial indicator. We show that a central bank using as sole instrument the interest rate cannot simultaneously improve inflation and credit cycles.

Credit market frictions and capital structure dynamics

We study the implications of credit market frictions for the dynamics of corporate capital structure and the risk of default of corporations. To do so, we develop a dynamic capital structure model in which firms face uncertainty regarding their ability to raise funds in credit markets and have to search for investors when seeking to adjust their capital structure. We provide a general analysis of shareholders' dynamic financing and default decisions, show when Markov perfect equilibria in financing and default barrier strategies exist, and when uniqueness can be achieved. We then use the model to generate a number of novel testable implications relating credit market frictions to target leverage, the pace and size of capital structure changes, creditor turnover, and the likelihood of default.

Government Size and Business Cycle Volatility: How Important are Credit Constraints?

In this paper we analyse how the availability of credit influences the relationship between government size as a proxy for fiscal stabilization policy and the amplitude of business cycle fluctuations in a sample of advanced OECD countries. Interpreting relatively low loan‐to‐value ratios as an indication of tight credit constraints, we find that government size exerts a stabilizing effect on output and consumption growth fluctuations only when credit constraints are relatively tight. Our results provide support for the hypothesis that credit market frictions play a crucial role in the transmission of fiscal policy.

Macro-Perspective on Asset Grants Programs: Occupational and Wealth Mobility

We provide a simple quantitative general equilibrium model of occupational choice with credit market frictions to analyze the aggregate and distributional effects of asset transfer programs. Asset transfer programs have a positive but transient effect on aggregate productivity, and a negative impact on the aggregate capital stock. On net they have a negative but small effect on per capita income. The effects are very heterogeneous across treated individuals. We compare the results in our model to those from recent randomized control trials and historical natural experiments.

The effects of credit subsidies on development

Under credit market imperfections, the marginal product of capital may not be equalized, resulting in misallocation and lower output. Preferential interest rate policies are often used to remedy the problem. This paper constructs a general equilibrium model with heterogeneous agents, imperfect enforcement and costly intermediation. Occupational choice and firm size are determined endogenously by an agent’s type (ability and net wealth) and credit market frictions. The credit program subsidizes the interest rate on loans and requires a fixed application cost, which might be null. We find that the credit subsidy policy has no significant effect on output, but it may have negative effects on wages. The program is largely a transfer from households to a small group of entrepreneurs with minor aggregate effects. We also provide estimates of the effects of reducing the frictions directly. When comparing differences in US output per capita in a baseline case to simulations with counterfactually high frictions, intermediation costs and enforcement explain about 20–25 % of the output gap. We include a transition analysis.

Frictions in Shadow Banking: Evidence from the Lending Behavior of Money Market Mutual Funds

We document frictions in money market mutual fund lending that lead to the transmission of distress across borrowers. Using novel security-level holdings data, we show that funds exposed to Eurozone banks suffered large outflows in mid-2011. These outflows had significant spillovers: non-European issuers relying on such funds raised less short-term debt financing. Issuer characteristics do not explain the results: holding fixed the issuer, funds with higher Eurozone exposure cut lending more. Due to credit market frictions, funds with low Eurozone exposure provided substitute financing only to issuers they had pre-existing relationships with, even though issuers are large, highly rated firms.