Firm equity risk, bank lending standards, and the macroeconomy

Abstract

This paper analyzes the impact of US firms’ equity risk on bank lending standards and on the macroeconomy for two groups: small and medium-large firms. The results indicate that a higher level of firm risk leads to a higher percentage of banks tightening their lending standards on commercial and industrial (C&I) loans, with a much larger effect for medium-large firms. The finding provides support for the Risk Management Hypothesis, under which banks decrease lending to risky borrowers to reduce credit risk. In addition, we found a one-for-one relationship between firm equity risk and C&I loan spread, signaling the channel of how firm risk transfers through the banking system to the rest of the economy. Finally, the impacts of an increase in firm risk on bank lending standards and the economy are amplified in a recession compared to an expansion.

Keywords:

• Credit risk
• risk management
• macroeconomics
• financial markets

JEL classification:

• C55
• C58
• E44
• E51
• G21
• G32

PUBLIC INTEREST STATEMENT

The paper attempts to explain the relationship between credit risk of firms, the possibility of a loss resulting from a firm’s failure to repay a loan, and bank lending practices. To measure risk, we use firm equity risk, which is derived from a firm’s stock returns. By construction, equity risk reflects volatility in a firm’s stock price, signaling its future cash flow and ability to repay debt. We then integrate the risk measure with bank lending standards and other key macroeconomic variables to study the channel of how firm risk transfers through the banking system to the rest of the economy. We apply a Factor-Augmented Vector Autoregressive (FAVAR) model to count for the large data set and endogeneity. We found that a higher level of firm risk leads to a higher percentage of banks tightening their lending standards on business loans. In addition, firm risk has a direct impact on borrowing rates, affecting GDP and investment as a result.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1. when $N$ is large and the number of principal components used is at least as large as the true number of factors, the principal components consistently recover the space spanned by both $F_t$ and $Y_t$. Hence, the part of space covered in ${\hat{C}}_t$ that is not covered in $Y_t$ is ${\hat{F}}_t.$.

2. Price puzzle found in the VAR literature is that a contractionary monetary policy shock results in an increase in the price level, rather than a decrease as standard economic theory would predict.

Additional information

Funding

The author received no direct funding for this research.

Notes on contributors

Hien Nguyen

This paper applies a large amount of data by incorporating microdata on firms with macrodata on the macroeconomy to provide a complete picture of risk transferring. Movements of the macroeconomy, which policymakers and businesses are particularly interested in, are the outcome of microeconomic decisions and interactions. A huge amount of new data at the disaggregated level is becoming available with the collection of information from the internet. By the same token, statistical tools are being developed and designed to study them that can trace these micro actions and their aggregated effects. The results of our study contribute to this new trend of research in the field of macro-finance. In addition, the 2008 financial crisis highlighted the importance of measuring and managing risk in financial institutions and the role of central banks as regulators and supervisors. The findings of our paper shed light on how credit risk is measured and transferred in the economy.