The financial accelerator hypothesis says that credit market distortions magnify economic shocks. Disturbances that would be small if markets were efficient are exaggerated and prolonged due to imperfections in credit and loan markets. In other words, credit market distortions destabilize the economy. The financial accelerator hypothesis is important because standard business cycle models require large, persistent disturbances to mimic the business cycles observed in the data. Because the financial accelerator amplifies and propagates shocks, it can potentially explain why business cycles are so significant even though the observed shocks are not.
This article uses an adverse selection model to reexamine the relationship between credit market imperfections and economic instability. The adverse selection problem distorts loan markets in a dynamic equilibrium model of business cycle fluctuations. The model has three central messages. First, while in some cases the distortions destabilize the economy, in others they cause the economy to be excessively stable. Stabilizing outcomes in the dynamic model are closely related to over investment outcomes in static models of credit market failure. Second, if investments are equity-financed or if borrowers and lenders write optimal contracts, the only equilibria that emerge are “stabilizer equilibria”. Third, in the adverse selection model, the empirical distinction between accelerators and stabilizers is surprisingly subtle. Many statistics seen as evidence in support of a financial accelerator are consistent with stabilizer equilibria.
The balance sheets of Japanese banks in the late 1990s were damaged by the enormous amount of non-performing loans (NPLs) that had accumulated over the previous decade. NPLs at the end of fiscal year for 1997 (March 1998) reached 30 trillion yen, or 5.5 percent of loans supplied by domestically licensed banks. 1 The write off of NPLs against equity leading to a sharp fall in the ratio of equity capital to assets (the book based capital to asset ratio) of domestically licensed banks in March 1998 was followed by a long lasting fall in the domestic lending growth (Figure 1). Domestic loans fell by 20 trillion yen, or about 4 percent during the three year period from April 1997 to March 2000. The BOJ’s tankan “lending attitude of financial institutions” diffusion indices also experienced sharp declines in March 1998.
Did this fall in bank capital, the “capital crunch”, cause the reduction in supply of bank loans, the “credit crunch” in the late 1990s? In order to satisfy the capital adequacy requirements, banks may have cut back on their lending in response to large losses of capital as issuing the new equity incurs costs associated with asymmetric information between investors and banks. When a banking system involves binding capital requirements, in addition to the standard reserve requirements, it will be possible that the limitation on the expansion of loans may be capital and not reserves.
As information intermediaries, financial analysts play an integral role in the capital market, providing earnings forecasts, buy/sell recommendations and other information to brokers, money managers and institutional investors. As financial analysts specialize in producing firm-specific information, analyst coverage constitutes a crucial part of the firm’s information environment. The significance of analyst coverage is well recognized in the accounting and finance literature. An extensive body of research has developed on the determinants of analyst coverage (for instance, Bhushan, 1989; Moyer, Chatfield, and Sisneros, 1989; O’Brien and Bhushan, 1990; Lang and Lundholm, 1996; Barth, Kasznik, and McNichols, 2001; Lang, Lins, and Miller, 2004; Baik, Kang, and Morton, 2007; Chen, Weiss, and Zheng, 2007; Autore, Kovacs, and Sharma, 2008). The evidence in the literature demonstrates that analyst coverage offers a myriad of benefits, such as a reduction of information asymmetry and an improvement in liquidity.
