Corporate Resilience to Banking Crises

Ross Levine is Professor of Finance at the University of California, Berkeley. This post is based on an article authored by Professor Levine; Chen Lin, Professor of Finance at the University of Hong Kong; and Wensi Xie, Assistant Professor of Finance at the Chinese University of Hong Kong.

Although banking crises are costly, common, and heavily researched, there is surprisingly little research on corporate resilience to systemic banking crises. In an earlier paper, [1] we showed that strong shareholder protection laws mitigate the adverse effects of banking crises by easing the ability of firms to issue equity when crises curtail the flow of bank credit to firms. But, other factors might also shape the ability of corporations to obtain financing during systemic banking crises.

In our new paper, Corporate Resilience to Banking Crises: The Roles of Trust and Trade Credit, which was recently made publicly available on SSRN, we examine whether social trust affects (a) the ability of firms to obtain financing through informal channels when crises reduce the flow of bank loans to firms and (b) the resilience of corporate profits and employment to systemic banking crises. Social trust refers to the expectations within a community that people will behave in honest and cooperative ways and the extent to which human interactions are governed by the norms of reciprocity and trustworthiness. Informal finance refers to short-term credit provision that occurs beyond the scope of a country’s formal financial and regulatory institutions. For example, firms often receive trade credit that does not involve collateral or promissory notes subject to formal judicial enforcement mechanisms. In communities where individuals are more confident that others will repay them—even when there are no formal enforcement mechanisms underpinning the extension of credit, trade credit is likely to flourish. Thus, when a systemic banking crisis impedes the normal bank-lending channel, social trust might facilitate corporate access to trade credit and partially offset the adverse effects of the crisis on corporate profits and employment. This could be the first-order effect since trade credit is large. It accounts for 25% of the average firm’s total debt liabilities in our sample of over 3500 firms across 34 countries from 1990 to 2011.

We discover that (1) social trust facilitates access to trade credit during systemic banking crises, (2) social trust dampens the harmful effects of the crisis on firm profits and employment, and (3) the resilience-enhancing effects of social trust are largest among firms that rely heavily on short-term funding. The connections between social trust and corporate financing, profits, and employment are economically meaningful. Consider a hypothetical “average” country that has the sample average value of social trust, and a “high-trust” country, where its Trust value is one standard deviation higher than the sample average. Among firms that rely heavily on short-term funding, our estimates suggest that trade credit, profits, and employment drop by 43%, 52%, and 18% less respectively in the high-trust country than they fall in the average country during a systemic banking crisis.

The results are robust to several potential confounding factors. First, if social trust shapes the reduction in lending during systemic banking crises, then our findings might reflect differences in the severity of crises, not the resilience of firms to similarly-sized banking crises. We, however, find that this is not the case: trust does not explain cross-country differences in the magnitude of loan reductions during crises and we control for this in our analyses. Second, social trust could be correlated with the operation of the formal legal system and corporate access to equity markets. If this were the case, then we would not be isolating the impact of social trust per se on corporate resilience to crises. This is not the case, however. When we control for differences in formal legal institutions, shareholder protection laws, and many other factors, we confirm the findings. Third, there might be concerns that high social trust countries might have different long-run trends in profits and employment and we are simply capturing these different trends. Again, this is not the case. After controlling for such trends, we continue to find that social trust facilitates access to trade credit and ameliorates the adverse effects of systemic banking crises on profits and employment.

The complete paper can be found here.

Endnotes:

[1] Levine, R., Lin, C., Xie, W., 2016. Spare tire? Stock markets, banking crises, and economic recoveries. Journal of Financial Economics 120, 81-101.
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