Although banking crises are costly, common, and heavily researched (e.g. Reinhardt and Rogoff 2009, Laeven 2011), there is surprisingly little research on corporate resilience to systemic banking crises. While almost all countries experience crises, corporations in different countries and industries respond very differently to those crises. In a recent paper, we show that strong shareholder protection laws mitigate the adverse effects of banking crises by easing the ability of corporations to issue equity when crises curtail their access to bank credit (Levine et al. 2016a). Other factors might also shape the ability of firms to obtain financing during banking crises.
In a new paper (Levine et al. 2016b), we examine whether social trust affects (a) the ability of firms to obtain financing through informal channels when crises reduce the flow of bank loans to firms, and (b) the resilience of corporate profits and employment to systemic banking crises. Social trust refers to the expectations within a community that people will behave in honest and cooperative ways, and the extent to which human interactions are governed by the norms of reciprocity and trustworthiness. Informal credit refers to credit provision that occurs beyond the scope of a country’s formal financial and regulatory institutions. For example, firms often receive trade credit that does not involve collateral or promissory notes subject to formal judicial enforcement mechanisms. Trade credit represents a large proportion of debt financing, accounting for 25% of the average firm’s total debt liabilities in our sample of over 3,500 firms across 34 countries from 1990 to 2011.
Existing research suggests how social trust could enhance corporate resilience to systemic banking crises. First, when a systemic banking crisis impedes the normal bank-lending channel (Cornett et al. 2011), access to trade credit could partially offset the reduction in bank loans and ameliorate the impact of the crisis on corporate profits and employment. While firms might prefer bank loans (Ayyagari et al. 2010), trade credit is a valuable option when bank loans are unavailable (Allen et al. 2005, Garcia-Appendini and Montoriol-Garriga, 2013). Second, social trust can facilitate the flow of trade credit since trade credit is not supported by formal judicial enforcement mechanisms. In communities where individuals are more confident that others will repay them, i.e. where there is high social trust, trade credit is likely to flourish. Thus, when a banking crisis impedes the normal bank-lending channel, social trust might facilitate corporate access to trade credit and partially offset the adverse effects of the crisis on corporate profits and employment.
We first evaluate what happens to corporate profitability, employment, and use of trade credit during a systemic banking crisis, while differentiating countries by their levels of social trust. We use a sample of about 3,600 manufacturing firms across 34 countries over the years 1990 to 2011. Our key explanatory variable is the interaction term between social trust (‘Trust’) and a crisis dummy that equals one in the start-year of a systemic banking crisis and remains one for the three years after the crisis (‘Crisis’). To date systemic banking crises, we rely on Laeven and Valencia (2012). To measure social trust, we compute the percentage of survey respondents who answer ‘most people can be trusted’ in response to the question in the World Values Survey: “Generally speaking, would you say that most people can be trusted, or that you can’t be too careful in dealing with people?”. We measure ‘Trust’ three years before the start of a country’s systemic banking crisis. We interpret greater values of the trust measure as suggesting that suppliers of trade credit are more confident about the trustworthiness of the demanders of such credit. If the key interaction term—Trust*Crisis—enters positively in our analyses, this suggests that, on average, social trust mitigates the fall in trade credit financing, firm profitability, and firm employment during systemic banking crises.
We discover that social trust (1) facilitates access to trade credit during systemic banking crises, and (2) dampens the harmful effects of the crisis on corporate profits and employment. The connections between social trust and corporate financing, profits, and employment are economically meaningful. Consider a hypothetical ‘average’ country that has the sample average value of social trust, and a ‘high-trust’ country, where its Trust value is one standard deviation higher than the sample average. Among firms that rely heavily on short-term funding, our estimates suggest that trade credit, profits, and employment drop by 43%, 52%, and 18% less in the high-trust country than they fall in the average country during a systemic banking crisis.
We next explore whether the relation between social trust and trade credit, profits, and employment differs across industries in a theoretically predictable manner. In particular, since trade credit is a closer substitute for a firm’s short-run liquidity needs than it is for long-term capital investments (Klapper et al. 2012), the resilience-enhancing effects of social trust should be greatest among firms that depend heavily on liquid funds. Thus, we not only assess whether corporations are more resilient to banking crises in higher-trust countries, we examine differences in the cross-industry resilience to such crises. To measure an industry’s short-run liquidity needs, we follow Raddatz (2006) and use the proportion of working capital financed by ongoing sales, so that higher values indicate greater dependence on short-run liquidity.
As suggested by theory, we find that the resilience-enhancing effects of social trust are largest among firms that rely heavily on liquidity funds. For example, Figure 1 shows that the drop in trade credit is smaller in high trust countries, especially among firms in industries that rely heavily on short-run liquidity. The same cross industry patterns also hold for corporate profitability and employment. The profits and employment of corporations in high-liquidity needs industries drop less relative to low-liquidity needs industry in comparatively high-trust countries. Thus, the cross-industry, cross-country analyses provide evidence consistent with the view that social trust makes corporations more resilient to banking crises.
Figure 1. Trade credit financing during a banking crisis, differentiating between high- and low-trust countries in high-liquidity-needs industries, and in low-liquidity-needs industries
Notes: Each bar in the figure represents the average change in the ratio of trade credit financing to total assets (Trade credit financing/Total assets). Specifically, we first calculate for each firm the difference between Trade credit financing/ Total assets during a crisis, [t, t+3], and before the crisis, [t-3, t-1]. We then average this difference across firms for four groups: high-liquidity-needs industries among high- vs. low-trust countries, and low-liquidity-needs industries among high- vs. low-trust countries.
The results are robust to several potential confounding factors. First, if social trust shapes the reduction in lending during systemic banking crises, then our findings might reflect differences in the severity of crises, not the resilience of firms to similarly-sized crises. However, we find that this is not the case – trust does not explain cross-country differences in the magnitude of loan reductions during crises and we control for this in our analyses. Second, social trust could be correlated with the operation of the formal legal system and corporate access to equity markets. If this were the case, then we would not be isolating the impact of social trust per se on corporate resilience to crises. This is not the case, however. When we control for differences in formal legal institutions, shareholder protection laws, and many other factors, we confirm the findings. Third, there might be concerns that high social trust countries might have different long-run trends in profits and employment, and we are simply capturing these different trends. Again, this is not the case. After controlling for such trends, we continue to find that social trust facilitates access to trade credit and ameliorates the adverse effects of systemic banking crises on profits and employment.
Allen, F., J Qian, J., and M Qian, M., (2005),. “Law, finance, and economic growth in China”, Journal of Financial Economics 77, 57–116.
Ayyagari, M., A Demirgüç-Kunt, A., and V Maksimovic, V., (2010),. “Formal versus informal finance: Evidence from China”, Review of Financial Studies 23, 3048–3097.
Cornett, M .M., J J McNutt, J.J, P E Strahan, and P.E., H Tehranian, H., (2011),. “Liquidity risk management and credit supply in the financial crisis”, Journal of Financial Economics 101, 297–312.
Garcia-Appendini, E., and J Montoriol-Garriga, J., (2013),. “Firms as liquidity providers: Evidence from the 2007–2008 financial crisis”, Journal of Financial Economics 109, 272–29.
Gatev, E., T Schuermann,, T., and P E Strahan, P.E., (2009),. “Managing bank liquidity risk: How deposit-loan synergies vary with market conditions”, Review of Financial Studies 22, 995–1020.
Kaufmann, D., A Kraay, and, A., M Mastruzzi, M., (2011),. “The worldwide governance indicators: Methodology and analytical issues”, Hague Journal on the Rule of Law 3, 220–246.
Klapper, L., L Laeven,, L., and R Rajan, R., (2012),. “Trade credit contracts”, Review of Financial Studies 25, 838–867.
Knack, S., and P Keefer, P., (1997),. “Does social capital have an economic payoff? A cross-country investigation”, Quarterly Journal of Economics 112, 1251–1288.
Laeven, L., (2011),. “Banking crises: A review”, Annual Review of Financial Economics 3, 17–40.
Laeven, L., and F Valencia, F., (2012),. “Systemic banking crises database”, IMF Economic Review 61, 225–270.
Levine, R., C Lin, and C., W Xie, W., (2016a),. “Spare tire? Stock markets, banking crises, and economic recoveries”, Journal of Financial Economics 120, 81–101
Levine, R, C Lin, and W Xie (2016b), “Corporate resilience to banking crises: The roles of trust and trade credit”, available at SSRN.
Raddatz, C., (2006),. “Liquidity needs and vulnerability to financial underdevelopment”, Journal of Financial Economics 80, 677–722.
Reinhart, C .M., and K Rogoff K., (2009), This time is different: eight centuries of financial folly. Princeton University Press