De-leveraging or de-risking? How banks cope with loss

Using detailed bank balance sheet data collected from the Dodd-Frank stress testing program, we examine how banks respond to a net worth shock. We make use of variation in banks' loan exposure to industries adversely affected by the oil price declines of 2014 and the implied variation in losses resulting from credit deterioration in those industries. In response to these losses, exposed banks reduced the risk of their balance sheets by shifting away from portfolio lending and shifting towards assets with lower risk weights. Banks tightened credit on corporate lending and on mortgages that they would ultimately hold in their portfolio. However, they expanded origination of mortgages that could be securitized and increased their holdings of agency mortgage backed securities. Our results imply that previous work suggesting that banks tighten credit in response to a shock (the traditional “bank lending channel” view) provides only a partial story and is in some ways misleading. It appears that banks respond to a negative shock by de-risking rather than a uniform reduction in lending. In terms of the ultimate impact on borrowers, we find that the shock had only a minimal impact on the overall quantity of loans supplied to firms or households, reflecting substitution to other sources of financing. This last finding does not necessarily negate the view that negative shocks to bank net worth lead to adverse effects on the overall economy (the “credit channel” view). Not all firms were able to substitute alternative funding sources to avoid the shock. Using bank survey data, we show that banks with high exposure to the oil shock raised loan rates and tightened loan covenants. Firms—particularly small firms—that retained their relationships with oil-exposed banks likely did so on worse terms. The findings have significant implications for regulatory policy and theories of financial frictions.