Sorting out the effect of credit supply*

We document that banks that cut lending more during the Great Recession were lending to riskier firms ex-ante. To understand the aggregate implications of this sorting pattern, we build an assignment model in which banks have heterogeneous costs to take on risky loans and firms have different credit risks. In the model, aggregate loan volume depends on the entire distribution of bank holding costs and firm credit risks. We then use our model to recover the change in the distribution of bank holding costs during the Great Recession and show that it explains two-thirds of the decline of aggregate loan volume during this period.

Automated summary

This study documents that banks that cut lending during the Great Recession were more likely to lend to risky firms in advance. Using an assignment model, the researchers show that the change in the distribution of bank holding costs accounts for two-thirds of the decline in aggregate loan volume during this period.