The Effects of Banks’ Health on the Growth and Leverage of Their Corporate Customers: A Quantitative Study of Danish Firm-bank Relationships Between 2008- 2013 in the Context of the Global Financial Crisis and International Banking Regulation

Abstract

The uniqueness of the banking sector and its ability to amplify shocks to the real economy has raised progressively more attention from both proponents of increased banking regulation and those in favor of a more relaxed regulatory environment. The transmission of bank distress to nonfinancial firms has given rise to a growing body of literature, where the health of the financial intermediary has real impact on borrowing firms. Considering the ramifications of bank health, which can in certain circumstances, lead to systemic failures, the proliferating nature of banking regulation is understandable. However, banking regulation, may at times hinder economic growth as opposed to advance it, and thus we argue a better understanding of the transmission of bank health, can pave the way for a more perceptive banking regulation, one which is grounded in real outcomes. To this end, we seek to provide empirical evidence on the effects of bank health on firm outcomes, addressing both the width and the depth of the impact. Our endeavor to answer the research question is grounded in an exploratory panel data study with a starting point in a review of bank health transmission as well as current and impending banking regulation. We document the macroeconomic and regulatory developments in Denmark during the period of interest, 2008-2013, to delve into the nature of the environment governing banks and firms. Through an assessment of existing studies of bank health transmission we build a comprehensive research of six firm outcomes spanning capital structure and growth. Granting to a unique opportunity, we advance an identification strategy that allows us to uncover the effects of regulatory capital injunctions to several Danish banks in 2010. We supplement the study of the injunction with a Z-score measurement of bank health for the period 2008-2013 period on an extensive dataset, which provides us the ability to pair firms and their primary lenders. The empirical analysis uncovered a significant effect of unhealthy banks, measured through the injunction, impacting firms’ leverage, interest expense, cash holdings and asset growth, while the Z-score proved itself a less conducive measure of analyzing bank health impact. Thus we evidence that unhealthy banks cause almost 5% less firm leverage, 24% increases in interest expense while cash holdings increase by 2.7% and a clear contraction in asset growth of 6.3%. The documentation of these effects provide further empirical evidence of the bank balance sheet channel as well as an insight in the transmission of bank health and banking regulation on the real economy. Keywords: Bank Health, Capital Structure, Firm Growth, Financial Regulation, Capital Requirements, Credit Supply, Capital Injunctions