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Uncertainty and the Cost of Bank vs. Bond Finance

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  • Grimme, Christian

Abstract

How does heightened uncertainty affect the costs of raising finance through the bond market and through bank loans? Empirically, I find that a rise in uncertainty is accompanied by an increase in corporate bond yields and a decrease in bank lending rates. This new stylized fact can be explained in a model with costly state verification and a special informational role for banks. In contrast to bond investors, banks acquire additional costly information about borrowers in times of uncertainty in order to reduce uncertainty. Having this information, the lending relationship becomes more valuable to the bank, resulting in a lower lending rate so that the relationship is not put at risk. The cost of bond finance increases because bond investors demand to be compensated for the increased risk of firm default. These findings suggest that the adverse effects of uncertainty are mitigated for firms that rely on bank finance as long as banks are highly capitalized.

Suggested Citation

  • Grimme, Christian, 2017. "Uncertainty and the Cost of Bank vs. Bond Finance," MPRA Paper 79852, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:79852
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    References listed on IDEAS

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    Keywords

    Uncertainty Shocks; Financial Frictions; Relationship Banking; Bank Loan Rate Setting; Information Acquisition;

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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