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E-MailRoss 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.
Over twenty-five years ago, Alan Greenspan, then Chairman of the Federal Reserve System, asserted that stock markets act as a “spare tire” during banking crises, providing an alternative corporate financing channel when banking systems “go flat.”
In our paper, Spare Tire? Stock Markets, Banking Crises, and Economic Recoveries, recently featured in the Journal of Financial Economics, we provide the first assessment of three core predictions emerging from this spare tire view. The first prediction is that if firms can issue equity at low cost when banking crises limit the flow of bank loans to firms, this will ameliorate the impact of the banking crisis on firm profits and employment. Second, when a systemic banking crisis reduces lending to firms, the benefits of a sound stock market will accrue primarily to firms that depend heavily on bank loans. For those firms that do not rely on financing from banks, the crisis is less likely to harm them in the first place. Third, the spare tire view stresses that the ability of the stock market to provide financing during a banking crisis, not the size of the market before the crisis, is what matters for how well stock markets reduce the harmful effects of banking crises on corporate performance. Although bank loans might be the preferred source of financing during normal times, the spare tire view holds that when this preferred source goes “flat,” equity issuances can, at least partially, substitute for bank loans. Critically, for the stock market to play this role, the legal infrastructure must be in place before the banking system falters. To push the analogy further, it is not the use of the spare tire before the regular tire goes flat that mitigates the adverse effects of getting a flat tire; it is having a sound spare in the trunk.
We assess these predictions by examining what happens to firm equity issuances, profitability, and employment across almost 3,600 firms, in 36 countries, over the period from 1990 through 2011. To measure the legal infrastructure shaping the ability of stock markets to provide financing during banking crises, we use an indicator of the strength of shareholder protection laws. The indicator gauges the degree to which the law protects minority shareholders from being expropriated by managers or controlling shareholders through self-dealing transactions. We interpret greater values of the anti-self-dealing index as indicating that outside investors will feel more confident about buying shares in companies, improving access to equity market financing.
The findings are consistent with the three predictions of the spare tire view. First, following systemic banking crises, firms (1) raise money through seasoned equity offerings, (2) experience smaller declines in firm profitability, and (3) fire fewer workers in countries with laws that effectively protect minority shareholders. The effects are large. In countries with a comparatively sound shareholder protection laws, the adverse impact of a systemic banking crisis on firm profitability and employment is one-third less than in countries with weaker protections of small shareholders. Second, the beneficial effects of shareholder protection laws during banking crises accrue primarily to firms that depend heavily on banks. Third, the results are consistent with the spare tire view that it is the pre-crisis legal infrastructure—not the size or liquidity of the stock market before the crisis—that shapes the ability of a stock market to act as a spare tire during a banking crisis. For example, the results hold when controlling for the level of stock market and banking sector development before the crisis.
Our results are also robust to a key concern: Perhaps, in countries with stronger shareholder protection laws, there are smaller reductions in lending associated with banking crises. If this were the case it would challenge our interpretation that stronger shareholder protection laws improve the ability of firms to adjust to crises. Three observations, however, suggest that our results do not reflect the impact of shareholder protection laws on changes in banking lending during crises. First, we show that shareholder protection laws do not account for cross-country differences in the reduction of bank credit during systemic banking crises. Second, even when controlling for the reduction in bank lending during crises, we continue to find that firms suffer smaller declines in profitability and fire fewer workers in countries with stronger shareholder protection laws. Third, if countries with stronger shareholder protection laws actually experienced smaller reductions in bank lending during crises, then there should not be an increase in equity issuances during crises. But, consistent with the spare tire view, we find that following the onset of crises, stronger shareholder protections are associated with greater equity financing than in economies with weaker such laws. Taken together, the findings are consistent with the spare tire view’s three predictions.
The full paper is available for download here.
