An important aspect of the economic crisis of 2008-2009 has been the contraction or “freezing” of credit to nonfinancial firms. During the crisis, financial firms have displayed considerable reluctance to extend loans to nonfinancial firms (as well as households). Some observers attributed the reluctance of financial firms to lend to irrational fear, while others attributed it to a rational assessment of the fundamentals of the economy, which can be expected to reduce the number of operating firms with good projects worthy of financing.
We analyze in this paper another factor that may contribute to the contraction of credit in such circumstances. In particular, we show how coordination failure among financial institutions can lead to inefficient “credit markets freeze” equilibria. In such equilibria, financial institutions rationally avoid lending to nonfinancial firms (operating firms) that have projects that would be worthy if banks did not withdraw from the lending market en masse. They do so out of self-fulfilling fear, validated in equilibrium, that other financial institutions would withhold loans and that operating companies would not be able to succeed in an environment in which other operating firms fail to obtain financing.
The primary contribution of the paper is in analyzing the effectiveness of various government policies in getting the economy out of such a self-fulfilling credit-freeze equilibrium. The analysis identifies the role and potential limitations of standard instruments such as interest rate cuts and infusion of capital into the financial sector. It also considers less traditional forms of intervention including direct intervention in lending to nonfinancial companies, provision of incentives to financial firms to lend to such companies, and supplying government capital to private funds dedicated to such lending – and analyzes why and when they may be needed. Our analysis provides a framework for understanding and assessing the range of instruments used by authorities to revive credit markets in the course of the financial crisis.
Our analysis is based on the premise (put forward in earlier work such as Cooper and John (1988)) that operating firms, or at least a significant fraction of such firms, benefit from the success of other operating firms in the economy, and the returns they will make on borrowed capital thus will increase if other operating firms are able to obtain financing. This interdependence can be generated by multiple channels. A firm’s success depends on the success of firms who use its products, of those who supply its inputs, and of those whose employees buy its products. As a result of this interdependence, the decision of any given financial institution whether to lend to a given operating firm depends not only on the financial institution’s assessment of the firm’s project but also on its expectations as to whether other financial institutions will lend money to other operating firms. (Below we refer to financial institutions as banks for simplicity.)
