Firm equity risk, bank lending standards, and the macroeconomy

Abstract

This paper analyzes the impact of US firms’ equity risk on bank lending standards and on the macroeconomy for two groups: small and medium-large firms. The results indicate that a higher level of firm risk leads to a higher percentage of banks tightening their lending standards on commercial and industrial (C&I) loans, with a much larger effect for medium-large firms. The finding provides support for the Risk Management Hypothesis, under which banks decrease lending to risky borrowers to reduce credit risk. In addition, we found a one-for-one relationship between firm equity risk and C&I loan spread, signaling the channel of how firm risk transfers through the banking system to the rest of the economy. Finally, the impacts of an increase in firm risk on bank lending standards and the economy are amplified in a recession compared to an expansion.