Lucian Bebchuk is Professor of Law, Economics, and Finance at Harvard Law School. Itay Goldstein is Associate Professor of Finance at the Wharton School of the University of Pennsylvania. Their recently published article Self-Fulfilling Credit Market Freezes was earlier issued as a discussion paper of the Harvard Law School Program on Corporate Governance.
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.
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