January 30, 2019

ECB published a paper that presents a comprehensive analysis of the sector- and firm-specific strategies that banks follow when their funding is affected by a negative shock. The authors focus on assessing the impact of bank funding shocks on credit allocation by banks, also providing evidence on the strategic lending decisions made by banks facing a negative funding shock and describing the implications of the findings for bank regulators.

The paper provides the results on the average impact of the interbank funding shock as well as the reallocation effects.Using bank-firm level credit data, the authors show that banks reallocate credit within their loan portfolio in at least three different ways. First, banks reallocate to sectors where they have a high market share. Second, they also reallocate to sectors in which they are more specialized. Third, they reallocate credit toward low-risk firms. These reallocation effects are economically large. A standard deviation increase in sector market share, sector specialization, or firm soundness reduces the transmission of the funding shock to credit supply by 22%, 8% and 10%, respectively. Overall, banks reallocate credit toward firms with low debt levels, low default risk, high available collateral, and a high interest coverage ratios. The paper also provides insights on the timing of funding shock impact and the timing of the reallocation channels. It investigates whether the funding shock has real effects on firm investment and growth, before presenting its conclusions.

The findings also contain interesting information for bank regulators. The results reveal a bright sight of lending concentration during the times of crisis and are thus informative when making the trade-off between portfolio concentration risk and having sufficient information about borrowers. Finally, the results suggest that not only systemic risk and financial stability issues should be taken into account when studying the welfare implications of portfolio diversification, but that it could also be relevant to consider the potentially beneficial impact of lending concentration on firm credit supply.

 

Related Link: Working Paper (PDF)

Keywords: Europe, EU, Banking, Concentration Risk, Systemic Risk, Credit Risk, Credit Allocation, Research, ECB

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