Self-Fulfilling Credit Market Freezes

A recent issue of the Review of Financial Studies featured (as lead article) our study “Self-Fulfilling Credit Market Freezes.” This paper develops a model of a self-fulfilling credit market freezes and uses it to study alternative governmental responses to such a crisis.

We study an economy in which operating firms are interdependent, with their success depending on the ability of other operating firms to obtain financing. In such an economy, an inefficient credit market freeze may arise in which banks abstain from lending to operating firms with good projects because of their self-fulfilling expectations that other banks will not be making such loans. Our model enables us to study the effectiveness of alternative measures for getting an economy out of an inefficient credit market freeze. In particular, we study the effectiveness of interest rate cuts, infusion of capital into banks, direct lending to operating firms by the government, and the provision of government capital or guarantees to finance or encourage privately-managed lending.

Our analysis provides a framework for analyzing the standard and nonstandard instruments used by authorities during the financial crisis of 2008-2009. This framework, we hope, can be useful for authorities making choices in the face of financial crises in the future. Our analysis also provides testable implications for – and can guide empirical work on – how firms, banks, and economies can be expected to be affected by shocks to the banking system.

We now turn to describing our analysis in a bit more detail: An important aspect of the economic crisis of 2008-2009 has been the contraction or “freezing” of credit to nonfinancial firms. During the crisis, financial firms have displayed considerable reluctance to extend loans to nonfinancial firms (as well as households). Some observers attributed the reluctance of financial firms to lend to irrational fear, while others attributed it to a rational assessment of the fundamentals of the economy, which can be expected to reduce the number of operating firms with good projects worthy of financing.

We analyze in this paper another factor that may contribute to the contraction of credit in such circumstances. In particular, we show how coordination failure among financial institutions can lead to inefficient “credit markets freeze” equilibria. In such equilibria, financial institutions rationally avoid lending to nonfinancial firms (operating firms) that have projects that would be worthy if banks did not withdraw from the lending market en masse. They do so out of self-fulfilling fear, validated in equilibrium, that other financial institutions would withhold loans and that operating companies would not be able to succeed in an environment in which other operating firms fail to obtain financing.

The primary contribution of the paper is in analyzing the effectiveness of various government policies in getting the economy out of such a self-fulfilling credit-freeze equilibrium. The analysis identifies the role and potential limitations of standard instruments such as interest rate cuts and infusion of capital into the financial sector. It also considers less traditional forms of intervention – including direct intervention in lending to nonfinancial companies, provision of incentives to financial firms to lend to such companies, and supplying government capital to private funds dedicated to such lending – and analyzes why and when they may be needed.

Our analysis is based on the premise (put forward in earlier work such as Cooper and John (1988)) that operating firms, or at least a significant fraction of such firms, benefit from the success of other operating firms in the economy, and the returns they will make on borrowed capital thus will increase if other operating firms are able to obtain financing. This interdependence can be generated by multiple channels. A firm’s success depends on the success of firms who use its products, of those who supply its inputs, and of those whose employees buy its products. As a result of this interdependence, the decision of any given financial institution whether to lend to a given operating firm depends not only on the financial institution’s assessment of the firm’s project but also on its expectations as to whether other financial institutions will lend money to other operating firms. (Below we refer to financial institutions as banks for simplicity.)

If fundamentals are sufficiently poor, it may be rational for banks not to lend regardless of what they expect other banks to do. And if fundamentals are sufficiently good, it may be rational for banks to lend regardless of what they expect other banks to do. However, given the positive spillovers among firms, there is an intermediate range of fundamentals that can give rise to multiple equilibria. In an efficient lending equilibrium, banks expect other banks to lend to operating firms with worthy projects, and these expectations are self-fulfilling. In an inefficient credit freeze equilibrium, banks have self-fulfilling expectations that other banks will withdraw from the lending market, and they rationally avoid lending to operating firms. We use the global-games methodology, where banks observe noisy signals about the macroeconomic fundamentals – which affect the profitability of real projects – to identify when an inefficient credit freeze arises in equilibrium. We also analyze the effect of various government policies on the probability of an inefficient freeze and on the overall wealth in the economy.

One standard policy measure to encourage lending is interest rate reduction. During the recent financial crisis, the Fed and other central banks around the world slashed interest rates. In our model, interest rate cuts by the central bank make an inefficient credit market freeze less likely by reducing the payoff to banks that avoid lending and invest in government bonds. Such cuts, however, still leave a range of fundamentals where the economy remains in an inefficient credit-freeze equilibrium, in which banks’ self-fulfilling expectations that other banks will not lend lead them to avoid lending to firms that would be worth funding if other banks were expected to lend.

Another prominent course of government policy works via capital infusion. Our analysis indicates that a shock to the banking system that depletes the amount of capital banks have makes an inefficient credit market freeze equilibrium more likely. Such depletion in the financial sector’s capital makes each bank more concerned that operating firms in the economy will not receive sufficient capital and therefore more reluctant to lend the capital it has to operating firms. As a result, intervention through the infusion of capital into banks, which governments in the US, UK, and other countries did throughout the financial crisis, can be beneficial and reduces the probability of a freeze in our model. However, we show that this measure, again, has limited effectiveness. Even when banks know that the banking sector’s capital is no longer depleted, there is still a range of macroeconomic fundamentals in which the economy remains in an inefficient credit freeze and banks avoid lending to operating firms that they would fund if other banks were expected to lend.

We then turn to examine the possibility of the government providing capital directly to operating firms. In macroeconomic circumstances in which an inefficient credit freeze arises, should the government serve as “lender of last resort” to operating firms? That is, should the government provide capital directly to Main Street rather than provide it to Wall Street with the hope that the banks will in turn lend it to operating firms? This has been attempted during the financial crisis when the government bought commercial paper of some firms. In our model, direct lending to operating firms is more effective in reducing the probability of a credit freeze, as it avoids the coordination problem among banks in lending the money. However, as long as the government does not have the same ability as banks to distinguish between operating firms with good and bad projects, direct lending to operating firms, without screening of such firms by intermediating banks, can waste resources by channeling capital to some firms with bad projects.

Thus, in some circumstances, providing the government’s capital to banks will fail to break an inefficient credit freeze, but providing this capital directly to operating firms will fail to take advantage of the screening expertise of private parties and hence to allocate capital among productive operating firms. Therefore, our analysis devotes considerable attention to alternative mechanisms under which the government harnesses the screening expertise of financial firms but also provides them with incentives to lend. For example, during the financial crisis, the US government has used the Term Asset-Backed Securities Loan Facility (TALF) to provide government capital, while limiting the downside risks of funds that extended certain types of credit to the nonfinancial economy. We analyze and compare the consequences of several alternative mechanisms. We identify their potential advantages and disadvantages relative to standard policy instruments as well as to each other. This analysis provides a rationale and framework for assessing and designing government-supported mechanisms to encourage lending while harnessing financial firms’ expertise.

Although we explicitly discuss lending by financial firms to nonfinancial operating firms, the basic insights of our analysis also apply to some lending by the financial sector to other nonfinancial borrowers, namely, individuals and households. That will be the case whenever there is interdependence among borrowers that makes the ability of some nonfinancial borrowers to repay loans to a given bank dependent on the ability of other nonfinancial borrowers to obtain financing from other banks. This might be the case, for example, in the housing market, where the expected resale value of any given house for which a loan is sought from a bank depends on future housing prices and thus might depend on the willingness of other banks to finance house purchases.

Our analysis has implications not only for policy-making in economic or financial crises but also for empirical work. In particular, for any given deterioration in fundamentals or shocks to banks’ capital, our model provides testable implications concerning the extent to which different firms, sectors, regions, and economies can be expected to suffer from credit contraction and the extent to which a given government intervention will spur lending. For example, following a shock to a banking sector, our model predicts that, other things equal, affected firms will have their credit contracted more when they are more dependent on each other (either on the demand or the supply side) and when the banking sector is less concentrated (and thus more prone to coordination failures). There is substantial empirical literature on the effect of shocks to banks’ capital on lending and investments, and our paper discusses in detail how our analysis can inform existing work as well as guide future empirical testing.

Our article is available here.