The Extent and Efficiency of Credit Reallocation during Economic Downturns

The extant theoretical literature on credit reallocation yields conflicting predictions on both the extent and the efficiency of reallocation during economic downturns. Using a comprehensive dataset of Japanese firms of all sizes spanning a period of more than 30 years, including the period of prolonged economic stagnation in the 1990s called "Japan's Lost Decade," we examine which predictions are consistent with the data to find the following: (1) the extent of credit reallocation is smaller in recessions than in expansions, which is attributable to the decreasing extent of credit creation; (2) this tendency was more pronounced during the Lost Decade, especially for small firms that experience a significant drop in the extent of both credit creation and destruction; and (3) credit reallocation generally is efficiency-enhancing, but it is less efficiency-enhancing in recessions and became efficiency-reducing during the Lost Decade, possibly due to financial assistance by banks to large but low-quality firms (e.g., through evergreening). These findings together suggest that the inefficient credit reallocation during the Lost Decade was characterized by efficiency-reducing reallocation for large firms and a low level of aggregate reallocation for small firms.