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Bank Lending During the Financial Crisis of 2008

By Harvard Law School Program on Corporate Governance

In the paper, Bank Lending during the Financial Crisis of 2008, forthcoming in the Journal of Financial Economics, my co-author, David Scharfstein, and I examine the effect of the banking panic of late 2008 on the supply of credit to the corporate sector. The paper documents that new loans to large U.S. borrowers fell by 47% during the peak period of the financial crisis (fourth quarter of 2008) relative to the prior quarter and by 79% relative to the peak of the credit boom (second quarter of 2007). New lending for real investment (such as working capital and capital expenditures) fell by only 14% in the last quarter of 2008, but contracted nearly as much as new lending for restructuring (LBOs, M&A, share repurchases) relative to the peak of the credit boom.

Some of the new lending decline, however, could have reflected a drop in demand as firms scaled back expansion plans during the recession. This question is addressed by examining the cross-sectional determinants of bank lending during the banking panic. In particular, the paper focuses on two factors: the extent to which a bank was financed by short-term debt rather than insured deposits, and its exposure to credit-line drawdowns. After the failure of Lehman Brothers in September 2008, there was a run by short-term bank creditors which made it difficult for banks to roll over their short-term debt. The paper shows that there was a simultaneous run by borrowers who drew down their credit lines, leading to a spike in commercial and industrial loans reported on bank balance sheets. Examining whether these two stresses on bank liquidity led banks to cut lending shows that: (i) banks cut their lending less if they had better access to deposit financings thus they were not as reliant on short-term debt, and (ii) banks that were more vulnerable to credit line drawdowns, because they co-syndicated more of their credit lines with Lehman Brothers, reduced their lending to a greater extent.

A drop in the supply of credit has important implications. Without a drop in supply, there would likely have been some attenuation of the drop in loan demand due to downward pressure on interest rate spreads. However, the drop in supply puts upward pressure on interest rate spreads, and leads to a greater fall in lending than one might see in a typical recession. The combination of a recession and a banking crisis is particularly problematic.

The full paper is available for download here.

Full post as published by The Harvard Law School Corporate Governance Blog on April 26, 2010 (boomark / email).