Do Financial Regulations Matter for Firm Performance? Evidence from Systemic Banking Crises

Transcription

1 Do Financial Regulations Matter for Firm Performance? Evidence from Systemic Banking Crises Varouj A. Aivazian University of Toronto Ding Ding University of Toronto Mohammad M. Rahaman Saint Mary s University This Version: September 17, 2013 Please Do Not Quote Without Permission Abstract How do financial market regulations affect firm performance? We investigate this question using episodes of systemic banking crises across many countries as identification tools for unanticipated credit contractions and compare firm investment, sales and inventory growth during the crisis and the post-crisis periods relative to the pre-crisis level averages. We exploit variations in our sample firms external financial dependence and financial constraints to show that credit contractions are costly for firms, but that the costs are borne disproportionately by financially constrained firms and also by firms normally relying more on the external capital market for their financing needs. Furthermore, declines in investment, sales, and inventory growth are greater for an externally dependent and financially constrained firm if the firm is also embedded in an ex-ante repressively regulated financial market compared to a similar firm embedded in a reformed financial market; these terms refer to the degree of financial market liberalization. Our results suggest that specific financial reform plays a significant role in attenuating the propagation of a banking crisis to the real sector. JEL Classification: E44, G28, G33, G34, P11 Key Words: Financial Regulations; Financial Reform; External Financial Dependence; Systemic Liquidity Shock; Credit Contraction; Banking Crises Varouj Aivazian is from the Department of Economics, University of Toronto. Ding Ding is from the Department of Economics, University of Toronto. Mohammad Rahaman is from the Sobey School of Business, Saint Mary s University. Varouj Aivazian can be reached at varouj.aivazian@utoronto.ca. Ding Ding can be reached at d.ding@utoronto.ca. Mohammad Rahaman can be reached at mohammad.rahaman@smu.ca.

2 1. Introduction The recent financial crisis has exposed the consequences and dangers from excessive risk-taking by financial institutions, and led to a reevaluation of the financial regulatory environment. The Basel Committee on Banking Supervision, consisting of regulators from 27 countries, has announced new regulations in response to the recent crisis. The premise is that financial regulation helps to improve financial systems and protect the economy from shocks in the financial sector. A number of extant studies investigate the effects of financial regulation on the real economy at the aggregate level; 1 this paper examines the effect of regulatory regimes on firm performance during credit contractions, analyzing the existence of a regulatory channel in attenuating adverse shocks. The paper uses episodes of systemic banking crises across many countries as an identification tool to examine the impact on the real sector of an unanticipated credit squeeze. We estimate the effects of various financial regulation regimes on firm investment, sales, and inventory growth during systemic banking crises. We combine the systemic crisis database by Laeven and Valencia (2008) with the extensive dataset on cross-country financial reforms from Abiad, Detragiache, and Tressel (2008) to investigate whether financial regulations can mitigate the adverse impact of financial instability on the economy. The question arises, why are episodes of systemic banking crises an appropriate means for testing the effects of financial regulations on firm performance? There are several answers. First, in a systemic banking crisis, liquidity and, in particular, loans by commercial banks shrink (Bernanke and 1 For examples, Rajan and Zingales (1998), Kroszner et al. (2007), Dell Ariccia et al. (2008), Huang (2008), Kerr and Nanda (2009), etc. 3

3 Gertler (1995)). As banks are the dominant sources of intermediated capital in most countries, a reduction in the supply of bank credit is likely to increase a firm s external finance premium 2 and reduce real economic activity. However, as Bernanke (2007) argues, the effect of a credit squeeze varies across firms and depends on the regulatory regime in which the firm operates. By focusing the analysis on systemic banking crises one can estimate the effect of a financial shock on firm performance in addition to identifying the effect of a specific financial regulatory environment. Second, most banking crises are sudden and dramatic. Although factors such as a weak macroeconomic environment and the structural characteristics of the banking sector have been found to predict banking crises, the precise timing of a crisis is difficult to determine (Demirguc-kunt and Detragiache, 1998). Hence a systemic banking crisis provides a good setting to analyze whether financial regulations amplify or attenuate the effect of credit contractions on firm performance. The degree to which a firm is affected by a banking crisis and a liquidity shock depends on its level of reliance on external financing. We exploit the variations in our sample firms external financial dependence and show that credit contractions are costly for firms, and more costly for more financially constrained firms, and that the costs are borne disproportionately by firms normally more reliant on the external capital market. Furthermore, we show that reductions in investment, sales and inventory growth are greater for externally dependent and financially constrained firms if they operate in (ex-ante) repressively regulated financial market compared to their peers in reformed financial markets. The extent of financial 2 Bernanke and Gertler (1995) define external finance premium as the difference in cost between funds raised externally (by issuing equity or debt) and funds generated internally (by retained earnings). 4

4 market regulation is defined more detail in Section 2 3. Our results suggest that specific financial reforms are important in attenuating adverse effects of banking crises. Two problems make it difficult to isolate the effects of financial market regulation and financial dependence. First, a systemic banking crisis may be accompanied by idiosyncratic negative shocks to investment opportunities and bank balance sheets and, as a result, firm performance may deteriorate because of reduced investment opportunities or because a credit contraction makes otherwise feasible investment opportunities less attainable. Second, an endogeneity problem arises if unobservables affect a firm s external financial dependence, investment, or the regulatory environment. These factors confound the effects of financial regulation with those of firm-specific shocks and bank balance sheet effects. To address these issues, we construct proxies for changes in firm growth opportunities, shocks to bank balance sheets, shocks to borrowers balance sheets or collateral, and for the strength of enforcement in the regulatory framework. We show that, after controlling for these confounding factors in our conditional OLS regressions, there remains a negative and statistically significant effect of pre-crisis external financial dependence and of financial constraints on at- and post-crisis firm performance, but the effect is weaker for a firm in a reformed financial market. Our results are robust with respect to the aforementioned endogeniety problem. The contributions of our paper are two-fold. First, it enhances our understanding of the effect of financial regulation on the real sector. Economists disagree on whether and to what extent financial regulations foster growth, and on strategies that foster and impede 3 The degree of repressive regulation versus liberalization after financial reform is defined by how a country scores in the financial liberalization index from Abiad et al. (2008), which amalgamates financial policy reforms along seven dimensions. The index is normalized between zero and one; a repressive regime is associated with a low score. The definitions are discussed further in Section 2. 5

5 growth. On the positive side, Barth, Caprio and Levine (2006), Barth et al. (2009), Beck, Demirguc-Kunt, and Levine (2006), Beck, Levine, and Levkov (2010), and Houston, Lin and Ma (2010) all argue that good financial regulations and supervisory practices increase the quality of financial services while reducing their costs, that they discourage corruption in credit allocation and exert larger impact on living standards of lower income households. On the negative side, Barth, Caprio and Levine (2006), Barth et al. (2009), Beck, Demirguc- Kunt, and Levine (2006), Beck, Levine, and Levkov (2010), Dinc (2005), Houston, Lin and Ma (2010), Khwaja and Mian (2005), Sapienza (2004) suggest that greater government involvement typically tilts the flow of credit to large, politically connected firms, boosting the opportunity for corruption and slowing growth and limiting economic opportunities for many. 4 We show that an (ex-ante) deregulated or reformed financial market can alleviate external financial constraints for firms during periods of pervasive illiquidity, in turn attenuating the detrimental effects of a credit squeeze on the real sector. Second, to the best of our knowledge, our paper is the first to study how interactions between systemic banking crises and ex-ante regulatory regimes (repressive versus reformed) affect firm performance. Past researchers have examined the impact of regulatory reforms on economic growth (Jayaratne and Strahan, 1996; Huang, 2008), entrepreneurship (Black and Strahan, 2002; Kerr and Nanda, 2009), economic volatility (Morgan, Rime, and Strahan, 2004; Demyanyk, Ostergaard, and Sorensen, 2007), and the wage gap between male and female bank executives (Black and Strahan, 2001). There is also evidence in the literature showing that financial market conditions financial regulations in particular and 4 See Levine (2011) for a discussion on both the positive and negative aspects of the financial regulation. 6

6 the macroeconomic environment affect a firm s ability to exploit investment opportunities efficiently and to grow. Rajan and Zingales (1998) show that industries that are more dependent on external financing grow faster in countries that are more financially developed and, arguably, less regulated. Kroszner et al. (2007) find that industries which are highly dependent on external finance tend to experience a greater contraction in value-added during a banking crisis in countries with more developed (less regulated) credit markets compared to those with less developed credit markets. Dell Ariccia et al. (2008) also find that banking crises have adverse effects (independent of business cycle effects) on sectors that are more dependent on external financing, but that the detrimental effects are stronger in less developed financial systems as firms in more developed financial systems are better able to secure alternative financing. These studies look either at the effects of regulatory reforms or of banking crises on aggregate and industry-level performance. Our paper investigates the combined effects of regulatory reforms and systemic banking crises on firm-level performance. The rest of the paper proceeds as follows. Section 2 describes the data and summary statistics. Section 3 presents the empirical methodology and results. Finally, Section 4 concludes the paper. 7

7 2. Data and Variables 2.1. Data We collect data on episodes of systemic banking crises across many countries from Laeven and Valencia (2008). 5 For the crisis-stricken countries in Laeven and Valencia (2008), we collect firm financial information from the Bureau van Dijk OSIRIS Industrial database. The database contains financial information on globally listed public companies in standardized and as-reported forms since We only use the standardized industrial firm financial data so that firm-level financial characteristics are comparable across different accounting jurisdictions. Also, we normalize firm characteristics by firm size (Total Assets) so that firm characteristics across different countries are free of currency denominations. Furthermore, as Bernanke (2007) argues, the impact of a credit contraction differs across firms of different sizes as large firms are more likely to have access to public debt markets, while small firms rely more on bank lending. Size-weighted financial ratios are more likely to reflect the characteristics of a typical medium-sized firm in the industry while equally-weighted financial ratios are more likely to reflect the characteristics of small firms. We then apply three additional filters: First, for each firm in a given country, we only keep observations from two years prior to the systemic banking crisis until three years after 5 Laeven and Valencia (2008) define a systemic banking crisis as follows: In a systemic banking crisis, a country s corporate and financial sectors experience a large number of defaults and financial institutions and corporations face great difficulties repaying contracts on time. As a result, non-performing loans increase sharply and all or most of the aggregate banking system capital is exhausted. This situation may be accompanied by depressed asset prices (such as equity and real estate prices) on the heels of run-ups before the crisis, sharp increases in real interest rates, and a slowdown or reversal in capital flows. In some cases, the crisis is triggered by depositor runs on banks, though in most cases it is a general realization that systemically important financial institutions are in distress. 8

8 the crisis. 6 For notational simplicity, we define the pre-crisis years (t=-1, and t=-2) as the pre-crisis periods, the onset of the systemic banking crisis (t=0) as the crisis year, and three years following the onset of the crisis (t=+1, t=+2, and t=+3) as the post-crisis periods. Second, the firm must be active in the industry during the pre- and the post-crisis periods. 7 Finally, we impose the restriction that the number of firms satisfying the first and the second conditions above must be more than 20 so that a country remains representative in our sample. In our final data set we have 4449 firms and firm-year observations in 13 different countries for the sample period of 1980 to The final estimation data set contains 14 banking crisis episodes in 13 countries (crisis year in parenthesis): Argentina (1995, 2001), China (1998), Finland (1991), India (1993), Japan (1997), South Korea (1997), Malaysia (1997), Mexico (1994), Norway (1991), Philippines (1997), Sweden (1991), Thailand (1997), and United States of America (1988). Finally, we collect information on financial regulations for our sample countries from Abiad, Detragiache, and Tressel (2008). They construct a database of financial reforms, covering 91 economies over the period The database records financial policy reforms along seven different dimensions: credit controls and reserve requirements, interest rate controls, entry barriers, state ownership, policies on securities markets, banking regulations, and restrictions on the capital account. Scores for each dimension are then combined to construct an overall financial liberalization index that is normalized to between zero and one. A low 6 A typical banking crisis lasts about three years following the onset of the crisis. Laeven and Valencia (2008) use a three-year period after the onset of the crisis to estimate the GDP loss to a country due to a systemic banking crisis. Demirguc-Kunt et al. (2006) also find that GDP growth returns to its pre-crisis level in the fourth year of the crisis. 7 We do not include inactive firms in our analysis for two reasons. First, we do not have complete information in the data set regarding why a firm is inactive. Second, since we are interested in comparing firm-level investment in the post-crisis periods compared to the pre-crisis periods, including inactive firms may introduce selection bias in our estimation. 8 Since we impose the restriction that we must have 3 years of firm-level data after the onset of the crisis, we cannot include the recent crisis that started in the U.K. and in the U.S. in the later part of 2007 and gradually spilled over to other countries. 9

9 score on the index implies a repressive regulatory regime while a high score implies a more liberalized financial system Main Variables Firm Investment: The primary dependent variable is the sequence of firm-level investments during the pre- and post-crisis periods. Since the sequence of investments in fixed assets is not readily available for most of our firms in the data set, we use a methodology developed by Lewellen and Badrinath (1997) to infer the actual sequence of new investments in fixed assets made by a firm. They use accounting identities to show that I it = NF it NF it 1 +D it, where I it is the new investment made by a firm i in year t, NF it is the net fixed assets in year t, NF it 1 is the net fixed assets in year t 1, and D it is the depreciation of fixed assets in year t. The identity shows that the amount of new capital expenditures a firm must have made during any year is the amount that accounts for the observed change in the firm s net fixed assets, plus the amount by which fixed assets would have declined during the year because of depreciation charges if no new expenditure had been made. Intermediary Financing: The primary explanatory variable is the exposure of a firm to a systemic liquidity shock. We argue that firms that are (ex ante) more reliant on intermediary financing are the ones more vulnerable to a systemic liquidity shock because their financing needs are more sensitive to debt rollover risk, capital market frictions, and price and non-price external debt finance contract terms, all of which typically emerge in a liquidity shock. This idea is not new in the literature. For instance, Rajan and Zingales (1998) use 10

10 a measure of external financial dependence to analyze the impact of financial constraints on growth. Kroszner et al (2007) also use a similar metric to proxy for sectoral external financial dependence. We follow the extant literature and measure the external financial dependence (EF D) for a firm as follows: EF D = Investment in Fixed Assets it Operating Cash Flows it Investment in Fixed Assets it where i indexes firm and t indexes year. We also refine the external financial dependence measure and construct an intermediary financial dependence (IF D) measure as: IF D = Investment in Fixed Assets it Operating Cash Flows it New Share Issue it Investment in Fixed Assets it The only difference between our intermediary financial dependence and the traditional external financial dependence measures as in Rajan and Zingales (1998) and Kroszner et al. (2007) is that we also subtract cash flows from new share issuance in addition to the operating cash flows from the investment in fixed assets. We estimate our regressions using both measures, and our results are virtually the same irrespective of the measure we use. This is because the cash flows associated with new share issuance during the sample periods are minimal, which is not surprising since during a systemic banking crisis new issues of securities are dramatically reduced. To be consistent with the previous literature, we report the results using the traditional external financial dependence measure in the paper, but the results using the intermediary financing measure are available upon request. 11

11 Depth of the Private Credit Market: An important variable related to our hypotheses 2 and 3 is the (ex ante) depth of a country s private credit market. We use the size of a country s private credit market relative to its Gross Domestic Product (GDP) to proxy for this variable. We collect this variable from Beck and Demirguc-Kunt (2009). They use data on private credit by deposit money banks and other non-depository financial institutions in a country and normalize these by the size of GDP of the country after deflating both measures by the consumer price index. Other Control Variables: We use a measure of asset tangibility (Fixed Assets/Total Assets) to control for firm size and collateral base. Asset tangibility also proxies for the level of uncertainty associated with firm value since tangible assets are easier to value compared to intangible assets. Fazzari and Petersen (1993) argue that in an imperfect capital market a firm s investment in fixed assets may compete with its investment in working capital. We use the average pre-crisis level of working capital (Current Assets - Current Liabilities) as an additional control variable in all our regressions. To control for a firm s debt maturity and financial leverage, we use Long-term Bank Debt/Total Assets and Total Liabilities/Total Assets, respectively. Finally, a firm s profitability could be a proxy for its internal financing capacity as well as an indication of future growth opportunities to the extent that current profitability conveys information on the future economic performance of the firm. We use Net Profits/Sales to proxy for the profitability of a firm. Among the country-specific variables, we use a dummy variable indicating whether the firm is in an OECD country to proxy for the level of economic development of a country. La Porta et al. (1997) show that a country s legal 12

12 institutions as well as investor protection rights are important in understanding the crosssectional variations in financial development and firm reliance on external capital markets. We use a measure of creditors right index from Djankov et al. (2008), and a dummy variable indicating whether a country s legal structure is based predominantly on English law from La Porta et al. (1997) to control for country-specific legal structure. 3. Empirical Analysis 3.1. Univariate Analysis Table 1 provides an overview of financial costs and financial market structure OF sample countries at the time of the banking crisis, as documented in Laeven and Valencia (2008). We note that there is significant cross-country variation in the extent of crisis impact and institutional characteristics. In terms of crisis intensity (non-performing loans, N P L), some countries had relatively low levels of NPL (e.g., U.S.A.(4.1%), Dominican Republic (9%), Croatia(10.5%)), whereas other countries recorded NPLs to the upwards of more than 30% of outstanding bank credit (e.g., Korea (35%), Uruguay (36.3%), Ecuador (40%)). In terms of measurable costs (fiscal cost F COST, output loss GDP L, and reduction in output growth GDP G) as a result of the crisis, countries again show a wide range of outcomes. The financial market structures that crisis countries are embedded in also differ greatly. Some countries have fairly advanced stock and credit markets with highly concentrated banking sectors, while others feature diverse market characteristics. In the sample, only in a few instances is 13

13 a systemic banking crisis accompanied by a currency crisis or a sovereign debt default crisis. 9 Table 2 further examines the institutional characteristics of the crisis countries (Panel A), and relationship between crisis impact and the structure of the capital market of a country (Panel B). Two points emerge from this table: First, systemic banking crises are mostly concentrated in civil law and upper-middle income countries. Second, aggregate output loss (GDPL) due to a systemic banking crisis is significantly higher for countries with deeper private credit markets as the correlation between CREDIT and GDPL is positive and statistically significant at the 5% level. The latter evidence is particularly important for our subsequent analysis in which we explore, at the firm-level, whether or not firms in deep credit markets suffer disproportionately more than firms in shallow credit markets. Table 1 and Table 2 are about here Table 3, 4, and 5 show the evolution of financial liberalization and reform of the sample countries using the liberalization scores per Abiad et al. (2008) 10 from the two-year period prior to and up to the year of the banking crisis. Countries show varying degrees of regulatory liberalization across the categories of regulations examined. However, almost all countries have relatively tight controls on credit ceiling as well as bank supervision. India has the least score in reform at 0.10 and 0.24, respectively, prior to and at the time of the crisis, and the United Kingdom, the United States, and Sweden have the highest scores at 0.95 to Prior to the crisis year, year-over-year changes in financial regulation measures tend towards more liberalization, though the magnitude is small. Most countries maintained 9 See Laeven and Valencia (2008) for precise definitions of currency and sovereign debt crisis. 10 See Abiad et al. (2008) for precise definition and scoring of the indices involved. 14

14 status quo in financial reform policies prior to the banking crisis, with a number of them implementing reform policies towards greater liberalization (Brazil, China, Hungary, Russia, etc) and others reversing policy (Argentina, Czech Republic, Finland, Equador, Thailand, and Korea). There is greater variation between pre-crisis and crisis-date conditions. In general, changes for any country tend to differ in direction, with further reforms on some dimensions and reversal on other dimensions. Table 6 summarizes the evolution of financial regulatory polices by presenting the mean and median scores across all countries at t = 2 to t = 3. On average, the trend is towards more liberalization and greater reform on all dimensions. Table 3, Table 4, Table 5, and Table 6 are about here Table 7 shows that a country s regulatory status may be correlated with its level of financial development and legal environment. Clearly, the extent of regulatory control in a country s financial market is correlated with its institutional characteristics. The existence of a strongly capitalized stock market is correlated with more liberalization in bank supervision, more bank privatization, less capital controls, and more financial reforms in general, which are statistically significant at the 5% level. A deep credit market is associated with the previously mentioned factors, and also with more liberal regulations in directed credit, credit controls, and interest-rate controls (again statistically significant at the 5% level). Countries that follow English common law tended to have greater entry barriers to the financial market, but also are more liberal in allowing bank privatization, capital controls, and financial reforms. 15

15 Table 7 is about here Table 8 sheds some light on how financial regulations impact on aggregate and firm-level performance during a banking crisis. In this table, we examine the correlation of countryand firm-level outcomes with the status of financial regulation for that country during the crisis. Note that, at the country level, greater restrictions on financial markets are associated (statistically significant at the 5% level) with lower levels of non-performing loans, fiscal costs during the crisis, and output loss. However, the corresponding correlation coefficients on firm-level outcomes appear have opposite signs on various dimensions, suggesting that firm-level analysis may reveal additional insights. Table 8 is about here To get a sense of the impact of a systemic banking crisis on firm-level variables, we compare in Table 9 firm characteristics at and after a crisis relative to pre-crisis average. The average pre-crisis firm characteristics for firm i are calculated as ȳ pre = y it 2+y it 1 2, where t is the year of the banking crisis. We then calculate the cumulative change in a firm characteristic from the onset of the crisis to three years after the crisis relative to the pre-crisis average for that characteristic ( y it+n ȳ pre 1, n = 1, 2, 3). Panel A of Table 9 shows the evolution of various firm characteristics for the median firm in our sample. It shows that such a firm s liquidity position deteriorates as its cash and marketable securities decline by 26.21% relative to their pre-crisis average level, and investment in working capital and access to trade-credit also decline by, respectively, 16.21% and 6.62% three years after the crisis. Firm level leverage also declines, but the fall in liabilities (TL) is mostly offset by 16

16 a rise in owners capital (EQUITY). As to firm performance, the table shows a cumulative decline in sales of 2.22% three years after the crisis while profitability decreases by almost 40% (PM, ROA, and ROE). Finally, investment in fixed assets decreases by 43.92% and there is less reliance on the external capital market as external financial dependence declines by 92.95% along with issuances of short- and long-term debt and equity. The evolution of firm characteristics shown in Panel A of Table 9 indicates that the rise in capital market frictions in a banking crisis reduces access to financing, firm performance and investment opportunities. The reductions in firm performance indicators are quantitatively important and comparable to extant estimates of costs of financial distress. Note that estimates in the literature of direct bankruptcy costs are typically in the 1.4% to 7.5% range (see, Altman, 1984; Lubben, 2000; LoPucki and Doherty, 2004) while those by Bris, Welch and Zhu (2006) range from zero to 20% of assets. Table 9 is about here The subsequent panels of Table 9 show changes in firm characteristics for various country groupings during and post crisis periods. In general, firms on average have deteriorated liquidity positions, loan capacity, sales, profitability, and investment during and after the crisis, relative to the pre-crisis benchmark average. The deterioration in firms liquidity positions following the crisis suggests the presence of a liquidity shock. It may be that if a sound financial regulation were in place, it would act to stabilize the financial system and prevent a severe credit crunch, benefiting in turn firm-level performance. In what follows, we focus our discussion on firm sales, profitability and investment. In Panel B, we examine the relative performance of median firms in countries with more repressive financial 17

17 regulations ex-ante versus countries with more liberalized systems. More repressive regimes are identified if the country s ex-ante financial liberalization index is below the 25 th percentile, while a more liberalized regime has an ex-ante index that is above the 75 th percentile. Note that the decline in firm sales, profitability and investment during the crisis and post-crisis periods (relative to the pre-crisis level averages) for a median firm in countries with more repressive regulatory regimes tend to suffer more on all dimensions immediately after the crisis. Firm investments continue to suffer disproportionately more for up to the third year after the crisis while profitability recover somewhat. This suggests a median firm in more liberalized regimes can absorb systemic shocks better than a median firm under relatively more repressive regimes. In other words, a country s regulatory environment has a role in mitigating the effects of a liquidity shock on firms. Note that bank lending increased in more financially regulated countries in the years after the crisis and was 22.85% higher in the third year after the crisis, suggesting that, governments in these countries are able to mitigate a credit crunch by prescribing banks to lend, thus ensuring liquidity provision to crisis-stricken firms. Accordingly, the median firm in more regulated countries recovers faster in terms of sales and profitability two and three years after the crisis. However, these firms do not fare as well in investment growth relative to their peers in the more liberalized group. Both Panels C and D examine the relative performance for firms that are ex-ante more externally financially dependent versus ones that are less so. External financial dependence in Panel C is determined by the proportion of capital investment not financed by cash flow from operations (EFD), while in Panel D, it is a financial constraint measure (FCINDEX) that follows Whited and Wu (2006). High EFD/FCINDEX firms are identified as those with 18

18 pre-crisis measures above the 75 th percentile and low EFD/FCINDEX firms are those at below the 25 th percentile. Both measures reveal similar patterns. While the median firm that is more financially dependent appear to be better at maintaining sales levels relative to the median firm that is less financially dependent, it fares consistently and significantly worse in the profitability and investment categories. Taken together, the evidence suggest that impact of a banking crisis is borne disproportionately by firms that are more financially dependent, which in turn highlights the importance of the health and status of financial systems for such firms. Consistent with this line of thought, the results suggest regulatory policies of financial systems have a role in mitigating the duration and intensity of impact Regression Analysis Baseline Regression Analysis As consistent with the literature, evidence in Section 3.1 show that financial development in a country is important to firm performance. Moreover, a firm s performance depends on its reliance on the financial system as measured by its dependence on external financing; a firm that is more reliant on external credit is more likely to be affected by a banking crisis and a liquidity shock. At the same time, we find evidence that there are significant differences in how much impact firms experience and how quickly they recover depending on the financial regulatory regime they are in. Thus, to understand the role of financial regulatory policies on the propagation of a banking crisis to firms, we regress post-crisis capital expenditure growth of firm i of industry j in country c on the interaction of the firm 19

19 i s external financial dependence and the country c s financial regulation from the pre-crisis period, in which the EF D i (external financial dependence) of firm i is defined following Rajan and Zingales (1998) as ( Investment in F ixed Assets i,t Operating Cash F lows i,t Investment in F ixed Assets i,t ) for any given period t, and the baseline regression is as follows: I post crisis i,j,c = ϑ + δ 1 EF D pre crisis i,j,c + δ 2 REG pre crisis c + ϕ 1 X pre crisis i,j,c + δ 3 EF D pre crisis i,j,c REG pre crisis c + ϕ 2 C pre crisis c + α j + β c + ε i,j,c (1) Note that the reported results uses growth in capital investment as an outcome variable, the same set of tests are repeated using growth in sales and growth. The results are both quantitatively and qualitatively similar. The post-crisis period denotes the time from the crisis to the following three years, and the pre-crisis period refers to the two years prior to the crisis. Therefore, I post crisis i,j,c is the cumulative change in firm i of industry j s postcrisis capital expenditure respect to the average pre-crisis level. REG pre crisis c is the average financial regulation score over the pre-crisis period for the various dimensions, as reported in the Abiad et al. (2008) study. X pre crisis i,j,c and C pre crisis c are controls for pre-crisis average firm characteristics and country characteristics, respectively. α j and β c are, respectively, industry and country fixed effects. The parameter of interest is δ 3, which represents the interaction of the effect of financial regulation with external financial dependence on firm investment. Given that we regress post-crisis variables on pre-crisis characteristics, the direction of causality is logical. It would also be sensible to argue that firms are unable to forecast a liquidity shock ensuing a banking crisis one or two years before a crisis, and this 20

20 rules out concerns of reverse causality. Table 10 provides estimates from the baseline OLS model. We test effects of regulation using the financial liberalization and reform indices collected from Abiad et al. (2008), as well as scores of individual financial regulatory policy components that constitute the indices. Note that the financial liberalization index reflects the level of regulations imposed on a financial system, whereas the reform indices (reversal, reform, large reform, and status quo) measure the pace of policy changes. 11 For the most part, given a firm s external financial dependence, more liberal equity markets, less restrictions on capital account transactions, and greater allowance for bank privatization are associated with lower investment growth immediately after the banking crisis. On the other hand, investment growth after a banking crisis is higher when there is less entry barriers for foreign banks into a domestic market. Overall, the results suggest post-crisis growth is boosted if a country has undergone a financial reform towards greater liberalization of the financial markets just before the crisis. The regulatory regime may influence firm-level outcomes through effects on financial constraints that a firm faces. A more efficient financial system reduces external financing constraints, allowing better access to financing of new investments. To test this mechanism, we re-estimate the baseline model and measure external financing constraint using the F CIDEX i. F CIDEX i refers to the Financial Constraint Index of a firm and is defined as in Whited and Wu (2006), which measures financial frictions that a firm faces. 12 Greater 11 Please refer to Abiad et al. (2008) for precise definitions of the reform indices. 12 F CIDEX = CF it DIV DUMMY it LT D it LNT A it ISG it SG it, where CF it is the ratio of cash-flow to total assets of firm i, DIV DUMMY it is a dummy variable indicating whether firm i paid any dividend in period t, LT D it is the ratio of long-term debt over total assets, LNT A it is the log of total assets, ISG it is the 3-digit SIC industry sales growth, and SG it is the firm sales growth. 21

21 financial constraints limit a firm s investment opportunities. We expect that a liquidity shock exacerbates financial frictions and if financial regulation help to improve the efficiency of the financial system, we would expect firms in reformed countries to perform better because they have better access to capital. As expected, the coefficient on the interaction term F CINDEX Reform is positive and statistically significant at the 5% level. Our results indicate that pre-crisis financial policy reform is important and is associated with positive investment growth recovery after the crisis, while maintaining a status quo negatively impacts growth. And this effect is achieved through improving the financial system to ease capital access for externally financially dependent firms and firms with financing constraints. Simultaneity bias may be present if we believe a growth shock could occur at the same time as the banking crisis, so that the observed effects may not be due to financial market frictions and regulations, but instead due to poor firm growth and hence of changed demand for external finance. To address this concern, we control explicitly for a firm s dynamic growth opportunities (GOP i ), which is measured as GOP i = RetainedEarnings/T otalassets NetIncome ROE and report the results in Table 12. As can be seen from columns 3 and 7, the positive effect of financial reform on post-crisis investment recovery remain and are statistically significant for both definitions of firm-level external financial dependence. At the time of crisis, governments often implement immediate policy measures aimed at protecting the financial system from further deterioration and restoring stability. Pertinent containment measures may range from suspension of withdrawals, emergency liquidity support, to government guarantee of deposits. Effective policies will mitigate the transmission 22

22 of liquidity shocks to the real sector, and therefore confound our estimate on the regulatory coefficient. We re-estimate the previous results with control for containment policies adopted by countries during crisis episodes using data collected from Laeven and Valencia (2008). The controls include whether or not authorities introduced a freeze on deposits, a bank holiday, and a blanket guarantee on deposits; provided liquidity support; and lowered reserve requirements. The results are very similar both qualitatively and quantitatively, and we report a sample in Table 13. Financial reform s positive effect on investment growth is almost identical as previously estimated. Debt contract enforcement plays an important role in encouraging the growth of credit markets and in improving the reliability of capital provision to firms. A number of studies since La Porta et al. (1997, 1998) find that debt contract enforcement and aggregate financial development are related positively. When strong debt contract enforcement practices accompany financial reform, we expect to observe stronger post-crisis recovery. To ensure our results are not capturing the effect due to better market conditions, we include a measure of debt enforcement in the regression, defined as the efficiency of debt contract enforcement mechanisms in a country, as obtained from Djankov et al. (2008). Columns (3) and (7) in Table 14 show that, when there is better debt contract enforcement, the coefficients on EF D Reform and F CINDEX Reform are stronger and improve in statistical significance. The transmission of a liquidity shock during the banking crisis may be affected by bank lending channel (Bernanke and Gertler (1995), Bernanke (2007)) and the balance sheet 23

23 channel (Bernanke and Gertler (1989)). The strength of bank balance sheets determines the supply of loanable funds banks are able to offer during a crisis, and affects the extent of transmission of financial shocks to the real sector. On the borrower side, variations in borrower net worth lead to fluctuations in real activity. In order to distinguish the regulatory channel we identify in this paper from the two existing channels, we introduce controls for bank balance sheet strength and borrower collateral fragility separately and then together in Tables 15, 16, and 17. Table 15 shows results for the viability of the banking sector accounted for via the ZSCORE. Table 16 controls for borrower deterioration by measuring changes in borrower collateral. Columns (3) and (7) in all three tables show that the regulatory channel through which pre-crisis financial reform attenuates crisis impact on firm growth is robust and statistically significant. 4. Conclusion We utilized variations in firms external financial dependence and financial constraints to show that credit contractions are costly for firms, and that the costs are borne disproportionately by more financially constrained firms and also by firms that are in normal times more reliant on the external capital market. Furthermore, declines in investment, sales, and inventory growth were shown to be greater for externally dependent and financially constrained firms if such firms are situated in ex-ante repressively regulated financial markets compared to similar firms embedded in more reformed financial markets. Our results suggest that specific financial reforms are important in attenuating the propagation of a banking crisis to 24

24 the real sector. Thus, the traditional line of argument - blame it on deregulation - is not be well supported by the data. 25

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