Natural disasters, firm activity, and damage to banks
Professor of Economics, Gakushuin University
For HOSONO Kaoru's full bio,
Associate Professor of Economics, Nihon University
For MIYAKAWA Daisuke's full bio,
Natural disasters affect firm activities both directly and indirectly. One prominent indirect effect is on firms' transaction partners, in particular - their banks. This column shows how damage to banks affects firm activities, such as capital investment and exports, using as a natural experiment Japan's 1995 Kobe earthquake. Bank damage has a significant and negative impact on both firm investment and on exports but this effect does not last very long.
Direct and indirect impacts of natural disasters
Natural disasters affect firm activities in a variety of ways. They disrupt business operations directly through the loss of lives and the destruction of buildings and equipment, and indirectly through the impact on firms' transaction partners such as their customers, suppliers, and providers of finance. While the direct damage of natural disasters often attracts the attention of the public and of policymakers, the indirect damage through transaction partners is often overlooked, even though it can be substantial. For example, a survey conducted in July 2012 following the Tohoku earthquake, which wreaked havoc in the northern part of Japan on 11 March 2011, suggests that 62.5% of firms in the Tohoku area suffered direct damage from the earthquake. In addition, 36.5% of firms also indicated that they were negatively affected by damage to their suppliers, and 44% stated that they were negatively affected by damage to their customers. Moreover, 11.4% of firms indicated that, following the earthquake, the bank that was their most important source of lending could not operate the branch with which they transacted. In addition, 4.8% of firms replied that they were adversely affected by the fact that the bank with which they transacted suffered damage as a result of the earthquake. These figures suggest that natural disasters such as earthquakes affect firms not only directly, but may also have a negative impact on their transaction partners, including their banks.
However, despite the potentially substantial indirect effects, much of the extant economic literature has focused solely on the direct impact of natural disasters and the recovery from them (see, e.g., Leiter et al. 2009, De Mel et al. 2012). As a result, our understanding of the indirect economic effects of natural disasters is limited; yet, a better understanding of such effects is indispensable for designing policies for recovery and the appropriate allocation of limited resources.
Among firms' transaction partners, suppliers of funding - especially banks - play a particularly important role in the process of economic recovery from natural disasters. When banks suffer physical or capital damage as a result of a natural disaster, they may not be able to provide sufficient funds at the same interest rates as before. In frictionless financial markets, firms should be able to offset such a negative shock to their funding by switching from a damaged to an undamaged bank, or raising funds from the financial markets. In practice, however, switching may involve substantial costs or time due to the role played by private information on firms' creditworthiness, potentially making it difficult for firms to obtain funds from alternative sources in a timely and cost-efficient manner. Thus, whether damage to banks affects firm activities or not is an empirical issue.
While there is a considerable body of literature examining banks' role in providing funding during normal times and times of financial crisis, there are relatively few studies that examine how impairment of banks' functioning in the wake of a natural disaster affects firm activities. Against this background, the aim of this column is to show how damage to banks affects firm activities, such as capital investment and exports, based on the results of studies we conducted on Japan's 1995 Kobe earthquake (Hosono et al. 2012, Miyakawa et al. 2014).
Empirical strategy to study financial constraints
Damage to banks is likely to undermine their lending capacity and to tighten the financial constraints that firms face when they undertake capital investment (Kahle and Stulz 2013) or start exports, i.e., the extensive margin of exports (Amiti and Weinstein 2011, Paravisini et al. 2011). Due to such financial constraints, firms may not be able to finance capital investment or the fixed costs associated with entering a foreign market (e.g., the costs of building a sales network abroad and adapting products to local tastes and regulations). Financial constraints may also restrict the volume of exports (i.e., the intensive margin of exports) of firms that have already started exporting due to a reduction in the amount of trade finance.
Although the theoretical predictions on the relationship between financial constraints and firm activities are straightforward, examining this relationship empirically is fraught with difficulties due to identification problems. That is, not only may lending by banks affect the performance of borrowing firms, but also borrowing firms' performance may have a significant impact on lenders' financial health and lending. Furthermore, there may be assortative matching between firms and banks (e.g., Sorensen 2007). Specifically, better-performing firms may be more likely to transact with better-performing banks. Both of these issues mean that it is difficult to clearly identify the direction of causality between bank lending and firm performance.
Two studies by a team of researchers of which we are members (Hosono et al. 2012 and Miyakawa et al. 2014) investigated the effects of bank damage due to a natural disaster on borrowing firms' capital investment and export behaviour. In order to circumvent the identification problems indicated above, the studies took advantage of the natural experiment provided by the 1995 Kobe earthquake. Devastating natural disasters such as the Kobe earthquake are likely to impose significant financial constraints on firms through the exogenous financial shock caused by the reduced lending capacity of banks from which firms borrow. For example, a natural disaster may obliterate information on borrowers' creditworthiness accumulated at the disaster-hit banks and thus destroy their managerial capacity to originate loans, including the ability to screen and process loan applications. Natural disasters may also cause damage to borrowing firms located in the disaster-hit areas, which may lead to a deterioration in banks' loan portfolios and hence weaken their risk-taking capacity. A reduction in credit supply from banks whose lending capacity has declined may have a negative impact on borrowing firms' activities through the mechanisms described above.
In the two studies mentioned above in order to separate out the purely exogenous shock to firms' financing stemming from the reduced lending capacity of banks, we specifically focused only on firms that did not suffer any direct damage of their own as a result of the disaster, but that were borrowing from damaged banks. If we focused on firms that suffered any direct damage of their own, our analysis would suffer from the identification problem described above. Any reduction in such firms' capital investment or exports might reflect their loss of assets or lack of production of goods to export rather than the effect of financial constraints due to damage to their banks. Thus, by focusing on non-damaged firms, we are able to extract the impact of the purely exogenous financial shock resulting from the earthquake. Employing this approach also circumvents any potential problem caused by positive assortative matching, since it would be implausible to assume that better-performing firms choose banks that are less likely to be hit by a natural disaster.
As mentioned above, there are very few studies that examine the adverse impact of a natural disaster through damage to banks, and there are only a limited number of studies that successfully overcome the aforementioned identification problems. One notable exception is the study by Amiti and Weinstein (2013), who used matched bank-firm loan data to identify idiosyncratic bank shocks and to examine the impact of loan supply shocks on firms' capital investment. Using Japanese data, they showed that idiosyncratic bank shocks have a large impact on firms' investment. Another notable study, this time focusing on exports, is that by Paravisini et al. (2011) who showed that a decline in credit due to the reversal of capital flows during the 2008 crisis reduced the intensive margin of exports, but had no effect on the extensive margin. Yet another example is the study by Amiti and Weinstein (2011) who employed Japanese firm-level data with information on each firm's main bank to examine the impact of the financial crisis in Japan during the 1990s on firm exports. They found that banks' financial health, measured by their market-to-book ratio, has a significant impact on the intensive margin of firms' exports, which suggests that bank financial health affects firm exports through the availability of trade finance. They also show that their results are not contaminated by a reverse causality. None of these studies, however, examined the role of financial constraints on firms' capital investment and export behaviour in the context of a natural disaster.
Evidence on the effects of bank damage on firm investment
The first of the two studies that we are introducing here, Hosono et al. (2012), focused on the effects of damage to banks on firms' investment activity. In the study, two alternative definitions of bank damage were used:
- Damage to a bank's headquarters, which is a dummy that takes value of one if the bank was headquartered in the earthquake-hit area, and aims to capture the decline in the bank's managerial capacity to process loan applications at the back office; and
- Damage to a bank's branch network, which is the ratio of the number of branch offices located inside the earthquake-affected area to the total number of branches and aims to capture the decline in the bank's financial health and risk-taking capacity.
The results of the study can be summarised as follows.
- First, firms located outside the earthquake-affected area, but associated with a main bank located inside the area, have a significantly lower investment ratio than firms outside the affected area associated with a main bank that was also located outside the area, indicating that bank damage has a negative impact on firm investment.
Moreover, this negative impact is not only statistically significant, but also economically significant. For example, in the case that bank damage is defined as damage to banks' headquarters, the investment ratio of undamaged firms whose main bank was damaged is 8.2 percentage points lower than that of undamaged firms whose main bank was not damaged. This impact is economically significant, given that the average investment ratio for undamaged firms in FY1995 was 13.1%. This result clearly implies that the exogenous damage to banks' lending capacity has a substantial adverse effect on firm investment.
- Second, the finding above is robust to the two alternative definitions of bank damage.
We interpret these results as evidence that financial constraints play an important role in the observed relationship between bank damage and the investment of firms outside the unaffected areas.
- Finally, bank damage, either to headquarters or branch networks, does not last for very long - three years after the earthquake the effect had dissipated.
Evidence on the effects of bank damage on firm exports
The second study, Miyakawa et al. (2014), examined the effects of damage to banks on firm exports. Specifically, like Hosono et al. (2012), the study focused on firms that were located outside the area affected by the 1995 Kobe earthquake and that were hence undamaged, and divided these firms into those whose main bank was located within the affected area and was damaged, and those whose main bank was not located in the affect area. The results of the study can be summarised as follows.
- First, as for the extensive margin of exports, we found that firms whose main bank is damaged are less likely to start exporting or expand the regions to which they export than firms whose main bank is unaffected.
Moreover, the impact of bank damage on undamaged firms is not only statistically but also economically significant. For example, the probability of starting exporting is 4.5 percentage points lower for firms whose main bank is damaged than for firms whose main bank is unaffected. This impact is substantial given that the average probability of starting exports of firms in unaffected areas in FY1995 was 4.4%. The negative impact increases to 6.7 percentage points for FY1996 before declining to 3.3 percentage points for FY1997. This finding suggests that the exogenous damage to banks' lending capacity has a substantial adverse effect on the extensive margin of firm exports.
- Furthermore, the finding holds regardless of which of the two alternative measures of bank damage, i.e., damage to a bank's headquarters or damage to a bank's branch network, is used.
Thus, our results imply that deterioration in banks' lending capacity has an important adverse impact on the extensive margin of exports. However, it is also interesting to note that although both measures of bank damage yielded significant results, there are some differences. Specifically, we find that whereas damage to a bank's headquarters affected firm exports in FY1995, the financial year immediately following the earthquake (i.e., in the financial year typically from April 1995 to March 1996; the earthquake occurred in January 1995), damage to a bank's branch network affected firm exports only a year later, in FY1996. This implies that the impairment of banks' managerial capacity affects firms' exports within a relatively short period of time, while the impairment of banks' financial health and risk-taking capacity only has a delayed effect.
- Second, as for the intensive margin, we found that a firm whose main bank is damaged has a lower export-to-sales ratio than a firm whose main bank is unaffected.
This finding is consistent with the prediction that the exogenous damage to banks' lending capacity has an adverse effect on the intensive margin of firm exports through a smaller provision of trade finance. Specifically, we found that in FY1995 the export-to-sales ratio of firms whose main bank was damaged was 6.5 percentage points lower than that of firms whose main bank was unaffected, while in FY1996 and FY1997 it was 7.4 and 6.5 percentage points lower, respectively. This impact is economically significant, given that the average export-to-sales ratio for firms in the unaffected areas was 9.1% in FY1995, 9.2% in FY1996, and 9.7% in FY1997.
Lessons from the empirical results
The results above imply that for economic recovery in the wake of a natural disaster, it is important to ensure that the functioning of financial intermediation is maintained so as to mitigate any potential financial constraints and allow firms to carry on with their capital spending and export plans. To this end, government support, including capital injection into banks affected by a natural disaster, as provided in the aftermath of the Tohoku earthquake, may be justified. In other words, in addition to speeding up recovery through the reconstruction of infrastructure and support for damaged firms, it may be necessary for the government to introduce policies for the purpose of mitigating a potential credit crunch triggered by the disaster. In this context, it should be noted that the analysis in the two studies focused solely on damage to a firm's main bank. Our results thus imply that firms are unable to fully offset the shock to their main lender bank by finding alternative sources of funding, providing further justification for government intervention in loan markets in the case of a massive natural disaster. At the same time, however, it is also important to note that our findings indicate that the negative effects of bank damage on firm activities do not last for a long time (Note 1). This means that government measures to intervene in the supply of credit should be timely and can be terminated within a short period.
Editor's Note: This column is based on research conducted by the authors while participating in the Study Group for Earthquake and Enterprise Dynamics (SEEDs), the project "Designing Industrial and Financial Networks to Achieve Sustainable Economic Growth" under the Ministry of Education, Culture, Sports, Science and Technology's programme "Promoting Social Science Research Aimed at Solutions of Near-Future Problems," "Hitotsubashi Project on Real Estate, Financial Crisis, and Economic Dynamics" (HIT-REFINED) supported by a JSPS Grant-in-Aid for Scientific Research (S), "Study Group on Corporate Finance and Firm Dynamics" at the Research Institute of Economy, Trade and Industry (RIETI), and the Social Scientific Survey on the Great East Japan Earthquake by the JSPS. We would like to express our thanks for having been given access to the firm-level data of the Basic Survey of Business Structure and Activities by the Ministry of Economy, Trade and Industry, and for the data provided by Teikoku Databank, Ltd. K. Hosono gratefully acknowledges financial support from Grant-in-Aid for Scientific Research (B) No. 22330098, JSPS.
This article first appeared on www.VoxEU.org on August 13, 2014. Reproduced with permission.
- ^ In most of the estimation results, the adverse impact associated with bank damage lasted a maximum of one year, starting either from FY1995 when we focused on damage to banks' headquarter or from FY1996 when we focused on damage to banks' branch network.
- Amiti, M and D Weinstein (2011), "Exports and Financial Shocks", Quarterly Journal of Economics 126 (4): 1841-1877.
- Amiti, M and D E Weinstein (2013), "How Much Do Bank shocks affect Investment? Evidence from Matched Bank-Firm Loan Data", NBER Working Paper 18890.
- De Mel, S, D McKenzie, and C Woodruff (2012), "Enterprise Recovery Following Natural Disasters", Economic Journal 122 (559): 64-91.
- Hosono, K, D Miyakawa, T Uchino, M Hazama, A Ono, H Uchida, and I Uesugi (2012), "Natural Disasters, Damage to Banks, and Firm Investment", RIETI Discussion Paper 12-E-062.
- Kahle, K and R Stulz (2013), "Access to Capital, Investment, and the Financial Crisis", Journal of Financial Economics 110 (2): 280-299.
- Leiter, A M, H Oberhofer, and P A Raschky (2009), "Creative Disasters? Flooding Effects on Capital, Labor and Productivity Within European Firms", Environmental and Resource Economics 43 (3): 333-350.
- Miyakawa, D, K Hosono, T Uchino, A Ono, H Uchida, and I Uesugi (2014), "Natural Disasters, Financial Shocks, and Firm Export", RIETI Discussion Paper 14-E-010.
- Paravisini, D, V Rappoport, P Schnabl, and D Wolfenzon (2011), "Dissecting the Effect of Credit Supply on Trade: Evidence from Matched Credit-Export Data", NBER Working Paper 16975.
- Sorensen, M (2007), "How Smart Is Smart Money? A Two-Sided Matching Model of Venture Capital", Journal of Finance 62 (6): 2725–2762.
August 19, 2014
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