2007 Reports

Collateral, Debt Capacity, and Corporate Investment: Evidence from a Natural Experiment

Gan, Jie

This paper examines how a shock to collateral value, caused by asset market fluctuations, influences the debt capacities and investments of firms. Using a source of exogenous variation in collateral value provided by the land market collapse in Japan, I find a large impact of collateral on the corporate investments of a large sample of manufacturing firms. For every 10 percent drop in collateral value, the investment rate of an average firm is reduced by 0.8 percentage point. Further, exploiting a unique data set of matched bank-firm lending, I provide direct evidence on the mechanism by which collateral affects investment. In particular, I show that collateral losses results in lower debt capacities: firms with greater collateral losses are less likely to sustain their banking relationships and, conditional on lending being renewed, they obtain a smaller amount of bank credit. Moreover, the collateral channel is independent of the contemporaneous influence of worsened bank financial conditions.