The increasing integration of the European banking industry offers the prospect of important gains in terms of efficiency and diversification, but it also creates potential risks. One such risk is associated with the possibility that a shock to a cross%border banks capital will result in a reduction in lending to firms and consumers in an economic environment that is uncorrelated with the origins of that shock. Given the size and penetration of a number of west European and U.S. banks in central and eastern Europe, their financial distress associated with the meltdown of subprime mortgages and securitized products in 2007 and 2008 and the run on banks by short term creditors, counterparties, and borrowers concerned about the liquidity and solvency of the banking sector, may have led to such a realization. The goal of this paper is to put this hypothesis to the test.
We investigate one key mechanism through which foreign financial distress may have been transmitted to local economic conditions, namely the supply of credit to small and medium enterprises. SMEs dominate the corporate landscape in central and eastern Europe, comprising up to 99% of all firms. Moreover, because of their opacity SMEs may be particularly vulnerable to contractions in the supply of credit. With this high dependency on the SME sector and with immature capital markets, banks are by far the main provider of funds for capital investment and expansion. An important feature of the central and eastern European banking market is its ownership structure. In particular, foreign ownership in the banking sector has grown so dramatically in the recent decade, that by 2008 foreign banks controlled around 80% of the assets in the the regions banking industry. The serious financial distress of pan European banks like Erste, KBC, and Societe Generale since 2007 stemming from economic circumstances unrelated to their operation in central and eastern Europe provides a natural experiment to study the channels through which the effects of the financial crisis that started in the U.S. spread through out the global economy.
Our key data come from a survey of a large group of SMEs in emerging Europe administered in April 2005 and April 2008. The data allow us to directly observe firms whose loan application was turned down over the course of the previous year, or which were discouraged from applying for bank credit by high rates and unfavorable collateral requirements. While we do not observe the bank which granted/denied the loan, we observe the extent of the operations of all banks present in the firms city of incorporation. By using balance sheet data on the parent banks, foreign or domestic, we construct an index of financial distress at the level of each locality in 14 countries in the region, which we then map into data on loan rejection rates. The final data consist of 4,421 firms in 1,266 localities served by a total of 141 banks over the 2005-2008 period. The majority of localities, however, are served by just a handful of banks, with foreign ownership of those varying by country and locality. This allows us to answer two important questions: 1) did banks transmit their financial distress by shrinking loans to business customers issued by their branches and subsidiaries in the early stages of the 2007n2008 crisis?, and 2) did foreign banks react differently from domestic banks to their respective financial troubles?
The classic problem with identifying a credit crunch is that firms demand shifts during a credit crunch following the deterioration of firms balance sheets. This wouldn't be an issue if we were studying the cross-border transmission of financial distress into an economic area insulated from that distress through all other channels but the bank lending channel. As the sub-prime mortgage crisis was associated since its very beginning with the expectations of a global recession, the measured effect of bank loan supply shocks will likely be contaminated by demand shifts. Some studies that identify demand use the decline in loan applications across differentially affected lenders to argue that there haven't been variations in the decrease in demand across lenders. One problem with that identification approach may be limited data availability on loan applications. However, even when one observes the universe of loan applications, it is still the case that applicant firms are a trunctated sub-sample of all firms. Some firms do not apply because they do not need credit, and some because they are discouraged. This implies a selection process which makes the sample of applicant firms not perfectly representative of the population. Then it could well be that for banks negatively affected by the crisis, it is the financially healthy borrowers that are selecting themselves out of the application process (firms that do well during a recession), while for other banks, it is the weak firms that do so, discouraged by news of a contraction in lending. Thus, at different types of banks, non%applicant firms may have systematically different reasons for selecting themselves out of the application process, confounding identification and making it difficult to separate the bank lending from the balance sheet channel.
We overcome this obstacle by employing observable survey information on firms that choose to select themselves out of the bank credit application process, be it because they were discouraged, or because they do not need credit. Thus we are able to account not just for the decrease in firms demand, but also for the composition of firms that account for the decrease in demand. While there is already extensive evidence on the real effects of this financial crisis, our paper is the only one we know of which simultaneously 1) studies the international transmission of financial distress, 2) accounts for the changes in loan demand, and 3) is able to purge the bank lending channel from the contamination which arises due to the changing composition of firms demanding bank credit during a recession. As such, our paper adds to a very scarce literature employing data on the selection process involved in the granting of business loans.
