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Lending Efficiency Shocks

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  • Kaiji Chen
  • Tao Zha

Abstract

This paper develops a theory in which shocks to the efficiency of information acquisition by financial intermediation translate into business cycle fluctuations via capital reallocation. In our theory, under costly verification, the bank chooses to only monitor the returns of those entrepreneurs with insufficient net worth. This distorts the existing capital allocation among entrepreneurs of different sizes. A crucial ingredient of the model is that the outcome of monitoring is random and depends on both the efficiency of monitoring and the resources devoted to policing the returns of a project. As a consequence, a negative shock to monitoring efficiency forces bank to increase monitoring intensity and reduce the loan toward small entrepreneurs. This results in an increase in productivity dispersion and a recession. Using the COMPUSTAT dataset, we find a significant countercyclical pattern for the relative capital productivity of small to large firms, and a procyclical capital allocation between them. Such an empirical observation distinguishes the lending efficiency shocks from other aggregate shocks as the sources of business cycles.

Suggested Citation

  • Kaiji Chen & Tao Zha, 2015. "Lending Efficiency Shocks," Emory Economics 1505, Department of Economics, Emory University (Atlanta).
  • Handle: RePEc:emo:wp2003:1505
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    1. Stock, James H. & Watson, Mark W., 1999. "Business cycle fluctuations in us macroeconomic time series," Handbook of Macroeconomics,in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 1, pages 3-64 Elsevier.
    2. Bernanke, Ben S. & Gertler, Mark & Gilchrist, Simon, 1999. "The financial accelerator in a quantitative business cycle framework," Handbook of Macroeconomics,in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 21, pages 1341-1393 Elsevier.
    3. Gilchrist, Simon & Himmelberg, Charles P., 1995. "Evidence on the role of cash flow for investment," Journal of Monetary Economics, Elsevier, vol. 36(3), pages 541-572, December.
    4. Jeremy Greenwood & Juan M. Sanchez & Cheng Wang, 2010. "Financing Development: The Role of Information Costs," American Economic Review, American Economic Association, vol. 100(4), pages 1875-1891, September.
    5. Rui Castro & Gian Luca Clementi & Yoonsoo Lee, 2008. "Cross-sectoral variation in firm-level idiosyncratic risk," Working Paper 0812, Federal Reserve Bank of Cleveland.
    6. Roberto Motto & Massimo Rostagno & Lawrence J. Christiano, 2010. "Financial Factors in Economic Fluctuations," 2010 Meeting Papers 141, Society for Economic Dynamics.
    7. Eisfeldt, Andrea L. & Rampini, Adriano A., 2006. "Capital reallocation and liquidity," Journal of Monetary Economics, Elsevier, vol. 53(3), pages 369-399, April.
    8. Ruediger Bachmann & Christian Bayer, 2009. "Firm-Specific Productivity Risk over the Business Cycle: Facts and Aggregate Implications," 2009 Meeting Papers 869, Society for Economic Dynamics.
    9. Chen, Kaiji & Song, Zheng, 2013. "Financial frictions on capital allocation: A transmission mechanism of TFP fluctuations," Journal of Monetary Economics, Elsevier, vol. 60(6), pages 683-703.
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