Credit during a crisis: The bond lending channel of monetary policy
The past few months have witnessed a meltdown of corporate bond markets. Due to the COVID-19 outbreak, euro investment-grade credit spreads widened by one percentage point, and the market capitalisation of IEAC (the most popular European corporate bond ETF) decreased from over €13 billion to €10 billion. Drastic spikes in spreads as well as cash shortages suggest grim prospects for the large number of firms relying on bond markets.
Meanwhile, policymakers have pledged unprecedented support to companies. Germany’s strategy encompasses €550 billion in new loans via its state-owned development bank (Garicano 2020), and the US has offered over $2 trillion in economic assistance, to both firms and households (Baldwin 2020). Other proposals suggest that governments must absorb the losses of the banking system if necessary (Beck 2020a). Indeed, as firms begin to exercise their liquidity insurance and draw down credit lines, regulators need to ensure that banks prevent any additional capital depletion (Acharya and Steffen 2020).
Amid evaporating demand and precipitous supply chain disruptions, many firms continue to rely on banks as relationship lenders to help at the height of an economic malaise. It would certainly be a propitious development if those intermediaries do not become the primary vector of crisis transmission (Beck 2020b). At the same time, bond financing has been rising at the expense of bank lending in recent years, especially in the euro area, where market financing was historically less developed than in the US. How does monetary policy effectiveness depend on the bond-bank share? This is an open, and consequential, issue as the stock of bond debt has become a significant concern for central bankers around the world. The question is particularly relevant in light of widespread lockdown measures, as well as in the face of the concomitant liquidity crisis and the approaching wave of rating downgrades.
In principle, as long as bonds and loans are not perfect substitutes, it is unclear how the pass-through of monetary policy changes with debt composition. Classical views of the bank lending channel emphasise the role of loans in monetary transmission and tend to model bond markets as a largely frictionless ‘spare tire’. However, frictions in bond financing seem relevant in practice. For instance, market debt is held by dispersed creditors and it is harder to renegotiate relative to bank loans (Bolton and Scharfstein 1996, Becker and Josephson 2016, Crouzet 2017). Compared to ‘relationship financing’, the rigidity of market debt can leave borrowers more exposed to economic shocks. Credible empirical investigations are thus crucial to making progress on this issue.
Debt heterogeneity and monetary transmission
In a recent paper (Darmouni et al. 2020), we use a high-frequency approach that combines identified monetary shocks with cross-sectional firm-level stock price reactions in the euro area to investigate how debt structure mediates the monetary transmission process. Since monetary policy decisions are endogenous and correlated with many determinants of firm behaviour, high-frequency methods have been remarkably successful in isolating monetary shocks (Nakamura and Steinsson 2018). Tracing the impact of those shocks on the real economy is nevertheless challenging, as firm-level outcomes tend to adjust at a much lower frequency.
We first show how to interpret stock market reactions to learn about the effect of monetary policy on firms. Illustrating our mechanism in a simple framework of debt structure, investment, and stock prices, we argue that the effect of a higher share of bond financing is ambiguous. While the bank lending channel implies a smaller shift in credit supply for bond-financed firms, the existence of frictions in bond financing dampens (and can even reverse) this effect. Specifically, because bonds are held widely, they are more rigid than relationship loans. Dispersed creditors can fail to coordinate on beneficial renegotiations and leave borrowers more exposed to economic shocks.
We find strong evidence that debt structure matters for the transmission of monetary policy in the data. Firms with more bond debt are relatively more affected by surprise interest rate changes. In particular, after a 25 basis point increase in interest rates, firms in the bottom quartile of the bonds-over-assets distribution have a 99 basis point lower stock return, relative to firms in the top quartile. This finding is hard to square with the bank lending channel, which would imply, irrespective of the exact micro-foundation, that bond-reliant firms are relatively less responsive—the opposite of what the data suggest.
On the other hand, this evidence is consistent with the existence of intense frictions in bond financing in the euro area. Importantly, the effect is equally forceful during the post-crisis period, when bond financing became much more prevalent. These findings are robust to several alternative specifications, including the inclusion of traditional balance sheet covariates that are thought to drive the response to monetary policy.
Evidence suggests the existence of frictions in bond markets that affect the ‘pass-through’ of monetary policy in the euro area, and several institutional features are consonant with this idea.
First, legal scholars have argued that the US is better equipped to deal with distressed bond-financed companies and that national insolvency laws in Europe are inadequate when it comes to producing efficient restructuring amid the rising importance of bond debt (Ehmke 2018).
Second, the European informational environment is distinct from the one in the US. While rating agencies are critical to the dissemination of information across dispersed bond creditors, the ECB estimates that, in 2004, only 11% of firms with turnover in excess of €50 million had an S&P rating in Europe, compared to 92% in the US. Sparseness of public information makes it difficult for a firm to access capital markets in bad times, which plausibly renders banking relationships more valuable in Europe. Indeed, in our sample of large public European firms, between 50% and 70% do not have such a rating. In the US by comparison, this number is between 10% and 15% (see Figure 1).
As an additional piece of supporting evidence, we show that rating downgrades have a stronger effect on euro area firms. The average stock market response to being downgraded from investment grade (BBB- and above) to speculative-grade (BB+ and below) is much stronger in Europe than the US. The raw data reveal that the difference is large and significant, corresponding to approximately five percentage points lower in Europe, relative to the US (see Figure 2).
Source: Darmouni et al. (2020).
Note: The figure displays the sample share by rating categories. The ratings encompass the three major rating agencies, that is, Moody’s, S&P and Fitch and are retrieved via Bloomberg. If there are multiple ratings for one entity the mean is computed. The sample consists of an unbalanced panel of the European firms that were part of EURO STOXX Supersector Eurozone indices, excluding financials and utilities.
Source: Darmouni et al. (2020).
Note: The figure displays rating downgrades across the US and Europe. The sample encompasses all entity ratings from the S&P rating panel available on WRDS. Changes from investment grade (BBB- and above) to speculative grade (BB+ and below) are defined to be rating downgrades. The top panel plots average raw returns with respect to the event date for the US and the euro area; the bottom panel plots the estimated differences.
A key implication is that mitigating frictions in bond financing is necessary to ensure that firms can truly diversify their funding sources away from bank credit. While bond issuance has been rising fast (thanks in no small part to expansionary monetary policy over the last decade), there is little evidence that bond market frictions have diminished at the same speed.
This situation should lead to an active effort on the part of euro area policymakers to improve the functioning of bond markets, especially in times of crisis and liquidity shortfalls. The outcome of the 2019 EU directive to reform insolvency laws should also be determinant. Notwithstanding, commentators have argued that the current proposal has critical flaws that could hamper credit market development (Becker 2019, Malakotipour et al. 2020).
Improving the functioning of euro area corporate bond markets is crucial for a successful ‘Capital Markets Union’. Besides, extensive periods of low long-term interest rates and quantitative easing have meant that a large share of the economy now borrows from the bond market, a trend that influences conventional interest rate policy transmission going forward.
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