Lending Efficiency Shocks

We use lending-standard data from the surveys of senior loans officers and banks' lending capacity to help identify the mechanism that translates shocks to the efficiency of information acquisition by financial institutions into business cycle fluctuations. Under costly verification, the bank chooses to monitor the returns of those entrepreneurs with insufficient net worth. This choice distorts the allocation of existing capital among entrepreneurs of different sizes. A crucial ingredient of the model is that the outcome of monitoring is endogenous, depending on both the efficiency of monitoring and the resources devoted to verifying the returns of a project. As a consequence, a negative shock to monitoring efficiency forces the bank to increase monitoring intensity and reduce loans for small entrepreneurs. This results in an increase in productivity dispersion and a recession. To validate our model, we use the COMPUSTAT dataset and find a significant countercyclical pattern for the relative capital productivity of small to large firms, and a procyclical capital allocation between small firms and large firms. Along with empirical support from the data on business lending capacity, these empirical findings reinforce the identification of lending efficiency shocks separate from other aggregate shocks as a source of financial frictions.