Do Stock Markets Provide a ‘Spare Tire’ When Banks Go Flat?
If firms can substitute equity sales for bank loans, then the crises will be less harmful to profit and employment. Although official entities and others have discussed the argument, nobody had systematically assessed the role of stock markets during banking crises until I and two co-authors did so.
In a paper, forthcoming in the Journal of Financial Economics, (“Spare Tire? Stock Markets, Banking Crises, and Economic Recoveries.”) Chen Lin, of Hong Kong University, and Wensi Xie, of the Chinese University of Hong Kong, and I test Greenspan’s hypothesis. (See an abbreviated version here on the Institute's site.)
The spare tire view makes three core predictions:
First, it stresses that the effects of a banking crisis on company performance are ameliorated if firms can issue equity at low cost when loans are difficult to obtain. Put differently, if a banking crisis shuts off bank lending and firms do not have an alternative source of financing, they suffer more than they do when market financing is available.
Second, in a crisis, the benefits of market financing accrue primarily to the firms that depend heavily on bank loans. Firms that do not rely on banks are less likely to be harmed.
Third, the spare tire view stresses the ability of the stock market to provide financing during a crisis, not the size of the market before the crisis. Although banks might normally be the preferred source of financing, the spare tire view holds that when they go “flat,” equity issuances can be substituted, at least partially. For the stock market to play this role, the appropriate legal infrastructure must be established before the crisis hits. This allows the market to respond when the banking system falters. It is the pre-crisis legal infrastructure — not necessarily the pre-crisis size of the stock market — that enables the market to act as a spare tire. To push the analogy further, it is not the use of the spare tire before the regular tire goes flat that mitigates the adverse effects of getting a flat; it is having a sound spare in the trunk.
We assessed these predictions by examining what happened to equity issuances, profitability and employment across almost 3,600 firms in 36 countries from 1990 through 2011. The findings are consistent with the predictions.
First, in countries with laws that protect minority shareholders, companies raise money through equity offerings, had smaller drops in profitability and fire fewer workers during systemic banking crises. The effects are large. In countries that have comparatively sound stock markets, the adverse impact of a systemic banking crisis on profitability and employment is one-third less than in countries with weaker markets.
Second, the beneficial effects of the stock market during a banking crisis accrue primarily to firms that depend heavily on banks. Third, the results are consistent with the spare tire view that it is the pre-crisis legal infrastructure — not the size or liquidity of the stock market before the crisis — that shapes the ability of a market to act as a spare tire.