Loan to Bond Substitution: An Empirical Analysis on the Functioning of the Substitution Channel for Eurozone Firms

By Francesco Ruggiero (University of Naples Federico II)

This paper contributes to the literature by enhancing the understanding of the link between bank debt and bond market debt in the Eurozone. This implication is particularly important for small firms that usually rely heavily on bank loans, and are likely to be excluded from the credit market during crises. In this paper, I find that firms based in the Eurozone can substitute bonds for loans in response to changing credit conditions. But the substitution is only partial, and firms will end up raising less funds than needed. Despite the bank centric feature of the European financial market that encourages firms to rely a lot on bank loans, bonds still serve as a substitute to loans. Firms in the Eurozone choose to substitute bonds for loans especially in periods in which the banking sector is in distress or the central bank implements policies to enhance credit.

The comparison with the U.S. firms (provided as benchmark) requires an in-depth analysis on the relative roles of the banking system and the financial market in Europe and the U.S. The divergence in results might indicate that policies enacted by the Fed in the U.S. might not be the best fit for European system. European Central Bank (“ECB”)  should thus tackle similar problems differently. In principle, the central bank’s expansive monetary policies should have affected bank lending positively as well. The reason why it did not work as expected along this transmission channel is that  the banks tend to hoard extra liquidity received from the ECB to deal with potential  sudden shortages in the future.

The full article is available here.