Do stock markets act as a ‘spare tire’ during banking crises, providing an alternative corporate financing channel and mitigating the economic severity of crises when the banking system goes flat?
In 1999, Alan Greenspan, then Chairman of the Federal Reserve System, argued that stock markets could mitigate the negative effects of banking crises, including more fragile businesses and greater unemployment. Using the analogy of a spare tire, he conjectured that banking crises in Japan and East Asia would have been less severe if those countries had built the necessary legal infrastructure so that their stock markets could have provided financing to corporations when their banking systems could not. If firms can substitute equity issuances for bank loans during banking crises, then banking crises will have less harmful effects on the public.
But researchers have not evaluated the spare tire view. Although official entities and others discuss the spare tire argument (e.g. US Financial Crisis Inquiry Commission 2011, Wessel 2009), we are unaware of systematic assessments of the testable implications emerging from Greenspan’s view of how financial markets can ease the effects of systemic banking failures.
In a recent paper, we provide the first assessment of the spare tire view, which has three core predictions (Levine et al 2015).
- First, the spare tire view stresses that if firms can issue equity at low cost when banking crises limit the flow of bank loans to firms, this will ameliorate the impact of the banking crisis on firm performance. Put differently, if a banking crisis shuts off bank lending and firms do not have an alternative source of financing, firms will suffer more than they would in the presence of a stock market that provides such an alternative source of external finance.
- Second, when a systemic banking crisis reduces lending to firms, the benefits of a sound stock market will accrue primarily to firms that depend heavily on bank loans. For those firms that do not rely on financing from banks, the crisis is less likely to harm them in the first place.
- Third, the spare tire view stresses the ability of the stock market to provide financing during a banking crisis, not the size of the market before the crisis. Although bank loans might be the preferred source of external financing during normal times, the spare tire view holds that when this preferred source goes ‘flat,’ equity issuances can, at least partially, substitute for bank loans. Critically, for the stock market to play this role, the legal infrastructure must be in place before the banking crisis, so that the market can respond when the banking system falters. It is the pre-crisis legal infrastructure – not necessarily the pre-crisis size of the stock market – that allows the market to act as a spare tire in times of crisis.
Figure 1. Firm equity issuances during a banking crisis, differentiating between countries with high and low anti-self-dealing index values
Notes: Each bar in the figure represents the average change in the ratio of the total amount of funds raised through IPOs and SEOs to total assets (Proceeds of IPO/SEO) for firms in countries with above (High) and below (Low) the median value of the Anti-self-dealing index respectively. Specifically, we first calculate for each firm the difference between Proceeds of IPO/SEO during a crisis, [t, t+3] and before the crisis, [t-3, t-1]. We then average this difference across all of the firms in High and Low Anti-self-dealing countries respectively.
Figure 2. Firm profits during a banking crisis, differentiating between countries with high and low anti-self-dealing index values
Notes: Each bar in the figure represents the average change of the ratio of earnings before income and taxes (EBIT) to total assets for firms in countries with above (High) and below (Low) the median value of the Anti-self-dealing index respectively. Specifically, we first calculate for each firm the difference between the ratio of EBIT to total assets during a crisis, [t, t+3] and before the crisis, [t-3, t-1]. We then average this difference across all of the firms in High and Low Anti-self-dealing countries respectively.
Figure 3. Firm employment during a banking crisis, differentiating between countries with high and low anti-self-dealing index values
Notes: Each bar in the figure represents the average change in the ratio of the number of employees to total assets for firms in countries with above (High) and below (Low) the median value of the Anti-self-dealing index respectively. We multiply the ratio by 100 for expositional purposes. Specifically, we first calculate for each firm the difference between the natural logarithm of the ratio of the number of employees to total assets during a crisis, [t, t+3] and before the crisis, [t-3, t-1]. We then average this difference across all of the firms in High and Low Anti-self-dealing countries respectively.
We assess these predictions by combining several datasets and employing a differences-in-differences methodology. We focus on three key dependent variables: the amount of money raised through equity issuances by firms, the profitability of firms, and firm employment. Our main sample includes about 3,600 firms, in 36 countries, over the period from 1990 through 2011.
The key explanatory variable is an interaction term – the interaction between the strength of a country’s shareholder protection laws and whether the country is experiencing a systemic banking crisis or not. This crisis dummy variable equals zero in the years before the onset of a systemic banking crisis, becomes one in the year of the onset of the crisis, and remains equal to one for the next three years. To date systemic banking crisis, we use the influential study by Laeven and Valencia (2012). To measure the strength of shareholder protection laws, we use the ‘anti-self-dealing’ index of Djankov et al. (2008), which gauges the degree to which the law protects minority shareholders from being expropriated by managers or controlling shareholders using self-dealing transactions. Thus, the anti-self-dealing index indicates the degree to which outside investors feel confident about buying shares in companies, which makes it easier for firms raise funds through equity issuances.
If this interaction term enters positively in the equity issuance, profit, or employment regressions, we interpret this as indicating that equity issuances, firm performance, and employment deteriorate less following a systemic crisis when the country has stronger shareholder protection laws. The regressions also include an assortment of time-varying country and firm characteristics, such as the size of the stock market before the crisis, the size of the banking crisis, other measures of institutional development, as well as firm and year fixed effects.
We also test whether the particular firms predicted by the spare tire view to benefit most from stronger shareholder protections actually do benefit most. The spare tire view stresses that firms that rely heavily on external finance will benefit more from the spare tire financing mechanisms fostered by stronger shareholder protection laws than other firms. Put differently, if some firms do not use bank financing, then having a replacement source of external finance will not matter much for their performance.
The findings are consistent with the three predictions of the spare tire view.
- First, following a systemic banking crisis, stronger shareholder protection laws facilitate equity financing by firms, reduce the drop in firm profitability following the crisis, and also mitigate the adverse effects of the systemic banking crisis on employment. These results are illustrated in Figures 1-3.
- Second, the mitigating effects of strong shareholder protection laws are especially strong in financially dependent industries. That is, among firms in financially dependent industries, equity financing, firm profits, and firm employment all fall by less following the onset of a systemic banking crisis in economies with higher values of the anti-self-dealing index than in economies with weaker shareholder protection laws.
- Third, the results are consistent with the spare tire view that it is the pre-crisis legal infrastructure – not the size or liquidity of the stock market before the crisis – that shapes an economy’s response to a banking crisis. That is we find that: (i) the level of stock market development before the crisis does not help account for the response to the crisis; and (ii) the results on shareholder protection laws hold when controlling for the level of stock market development before the crisis.
The estimated economic effects are large. Consider two countries, one that has the sample average value of the anti-self-dealing index and the other that has a one standard deviation larger anti-self-dealing index. If both countries have average values of the other country characteristics, our estimates indicate that in response to a banking crisis, firms in the stronger anti-self-dealing country will experience a 36% smaller drop in profitability than firms in the country with comparatively weak shareholder protection laws. Furthermore, in highly financially dependent industries, the estimates suggest that firms in the stronger anti-self-dealing country will raise 82% more funds through new equity issuances than those in the country with average shareholder protection laws.
Djankov, S, R La Porta, F Lopez-de-Silanes and A Shleifer (2008), “The law and economics of self-dealing”, Journal of Financial Economics, 88: 430-465.
Greenspan, A (1999), “Do efficient financial markets mitigate financial crises?”, before the financial markets conference of the Federal Reserve Bank of Atlanta, Sea Island, Georgia.
Laeven, L and F Valencia (2012), “Systemic banking crises database”, IMF Economic Review, 61(2): 225-270.
Levine, R, C Lin and W Xie (2015), “Spare tire? Stock markets, banking crises, and economic recoveries”, Journal of Financial Economics, forthcoming.
National Commission on the Causes and Consequences of the Financial and Economic Crisis in the United States (2011), The Financial Crisis Inquiry Report New York, NY: Public Affairs.
Wessel, D (2009), In Fed We Trust, New York, NY: Crown Publishing Group.