NATURAL DISASTERS, DAMAGE TO BANKS, AND FIRM INVESTMENT

• Published date: 01 November 2016
• DOI: http://doi.org/10.1111/iere.12200
• Author: Makoto Hazama,Iichiro Uesugi,Arito Ono,Hirofumi Uchida,Taisuke Uchino,Kaoru Hosono,Daisuke Miyakawa
• Date: 01 November 2016

INTERNATIONAL ECONOMIC REVIEW

Vol. 57, No. 4, November 2016

NATURAL DISASTERS, DAMAGE TO BANKS, AND FIRM INVESTMENT∗

BYKAORU HOSONO,DAISUKE MIYAKAWA,TAISUKE UCHINO,MAKOTO HAZAMA,

ARITO ONO,HIROFUMI UCHIDA,AND IICHIRO UESUGI1

Gakushuin University/RIETI, Japan; Hitotsubashi University, Japan; DaitoBunka

University/RIETI, Japan; Hitotsubashi University, Japan; Chuo University, Japan; Kobe

University, Japan; Hitotsubashi University/RIETI, Japan

This article investigates the effect of banks’ lending capacity on firms’ investment. To identify exogenous shocks to

loan supply, we utilize the natural experiment provided by Japan’s Great Hanshin-Awaji earthquake in 1995. Using a

unique data set that allows us to identify firms and banks in the earthquake-affected areas, we find that the investment

ratio of firms located outside the earthquake-affected areas but having a main bank inside the areas was significantly

smaller than that of firms located outside the areas and having a main bank outside the areas. Our findings suggest that

loan supply shocks affect firm investment.

1. INTRODUCTION

Does the lending capacity of banks affect the activities of firms that borrow from those banks?

A vast literature has tried to answer this question since the seminal work by Bernanke (1983).

However, researchers are faced with an identification problem: although lending behavior

affects borrowing firms’ performance, the performance of borrowing firms itself has a significant

impact on the way lenders extend loans. This article tackles this problem by taking advantage

of the natural experiment provided by a natural disaster, which allows us to single out a purely

exogenous shock to firms’ bank financing.

A natural disaster may obliterate information on borrowers’ creditworthiness accumulated

by banks and destroy their managerial capacity to originate loans, including the ability to

screen and process loan applications. A natural disaster may also cause damage to borrowing

firms located in the neighborhood of such banks, leading to a deterioration in the banks’ loan

portfolios and risk-taking capacity. In either case, a disaster reduces the damaged banks’ lending

capacity. Thus, for those firms that are not directly damaged by the disaster, damage to banks

that they borrow from is an exogenous shock that may affect the availability and the cost of

∗Manuscript received February 2013; revised May 2015.

1We thank three anonymous referees for helpful comments. We are indebted to Naohisa Hirakata, Peter K. Schott,

Michio Suzuki, and other participants at NBER Japan Project Meeting 2012, Summer Workshop on Economic Theory

(SWET) 2012, and HIT-TDB-RIETI International Workshop on the Economics of Interfirm Networks for insightful

comments. This research was 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 program “Promoting

Social Science Research Aimed at Solutions of Near-Future Problems,” the “Hitotsubashi Project on Real Estate,

Financial Crisis, and Economic Dynamics” (HIT-REFINED) supported by a JSPS Grant-in-Aid for Scientific Research

(S), and the “Study Group on Corporate Finance and Firm Dynamics” at the Research Institute of Economy, Trade

and Industry (RIETI). We are grateful for permission to use the microdata pertaining to the 1995–1997 Basic Survey

of Japanese Business Structure and Activities (Kigyo Katsudo Kihon Chosa) conducted by the Ministry of Economy,

Trade and Industry. We are also thankful for financial support from Hitotsubashi University and for the data provided

by Teikoku Databank, Ltd. K. Hosono gratefully acknowledges the financial support received from the Grant-in-

Aid for Scientific Research (B) No. 22330098, JSPS, H. Uchida acknowledges support from the Grant-in-Aid for

Scientific Research (B) No. 24330103, JSPS, and D. Miyakawa acknowledges support from the Grant-in-Aid for Young

Scientists (Start-up) No. 26885087. Please address correspondence to: Kaoru Hosono, Gakushuin University, Mejiro

1-5-1, Toshima-ku, Tokyo 171-8588, Japan. E-mail: kaoru.hosono@gakushuin.ac.jp.

1335

C

(2016) by the Economics Department of the University of Pennsylvania and the Osaka University Institute of Social

and Economic Research Association

1336 HOSONO ET AL.

external funds they can access. A natural disaster thus provides us with a good “laboratory” for

studying the effect of banks’ lending capacity on borrowing firms’ investment.

Given this, the present study focuses on the Great Hanshin-Awaji (Kobe) earthquake, which

hit the areas around Kobe City and Awaji Island in western Japan in January 1995. Our primary

goal is to examine whether damage to banks had an adverse impact on the investment of client

firms that did not themselves suffer any damage. This question is important from the viewpoint

of identifying purely exogenous financial shocks. In addition, we also examine how damaged

firms recovered after the earthquake, i.e., whether damaged firms increased capital investment

relative to undamaged firms and whether damage to banks negatively affected damaged firms’

investment. To answer these important questions, we construct and use a unique firm-level

data set for both damaged and undamaged firms compiled from various sources. The data

set includes information on firms’ main banks,2on their investment levels, and on whether

these banks and firms were located inside or outside the earthquake-affected areas. The data

set also includes information from firms’ and banks’ financial statements. Thus, our sample

consists of four groups of firm–bank pairs—namely, damaged and undamaged firms paired with

damaged or undamaged banks—and comparing undamaged firm–damaged bank pairs with

undamaged firm–undamaged bank pairs allows us to single out the effect of damage to banks

on the investment of undamaged firms.

Our main findings can be summarized as follows: First, firms located outside the earthquake-

affected areas but associated with a main bank located inside the areas had a lower investment

ratio than outside firms associated with a main bank located outside the areas. This result implies

that the exogenous damage to banks’ lending capacity had a significant adverse effect on firm

investment. Second, the above finding holds regardless of which of the following two alternative

measures of bank damage is used: (a) damage to a bank’s headquarters, which captures the

decline in a bank’s managerial capacity to process loan applications at the back office, and (b)

damage to a bank’s branch network, which captures the decline in a bank’s financial health and

risk-taking capacity.

The results are robust to a variety of checks such as using different measures of bank damage

from the above two baseline measures as well as controlling for unobservable firm heterogene-

ity and using different subsamples. Further, examining changes in firm–bank loan relationships

following the earthquake, we find that earthquake-affected banks became relatively less impor-

tant for firms in terms of their ranking in firms’ list of banks that they transacted with, implying

that affected banks supplied relatively fewer loans in the wake of the earthquake. The decline in

earthquake-affected banks’ ranking provides evidence that the observed relationship between

bank damage and the investment activity of firms located outside the affected area reflects the

role of financial linkages.

The contribution of this study to the literature is twofold.3First, by using a natural experiment,

the study presents a way to circumvent the identification problem encountered in many previous

studies on the effects of bank lending on firm activities—namely, the difficulty in distinguishing

between a loan supply shock and a loan demand shock. Matched firm–bank data also make it

possible to more precisely identify the mechanism through which the lending capacity of banks

affects the activities of borrowing firms than many other studies that are based on aggregate data

(e.g., Peek and Rosengren, 2000). Second, this study contributes to the literature investigating

the effects of natural disasters on corporate activities. Many of these studies use country- or

region-level data and thus are unable to clarify the effects of disasters on individual firms.

Notable exceptions are the studies by Leiter et al. (2009) and De Mel et al. (2012), which

examine the recovery of disaster-hit firms using a firm-level data set. Our analysis, however,

goes one step further and investigates the impact of damage to banks not only on earthquake-hit

firms but also on undamaged firms.

2Our data set includes information on the banks that firms transact with. Among those banks, we treat the bank that

a firm regards as the “most important” as the firm’s main bank. See Sections 4 and 5 for more details.

3See Section 2 for more details.

NATURAL DISASTER AND FIRM INVESTMENT 1337

The remainder of the study is structured as follows: Section 2 reviews the related literature

and outlines the contribution of the present study in greater detail. Section 3 then provides a

brief overview of the Kobe earthquake. Next, Sections 4 and 5 describe our data and method-

ology, respectively, whereas Section 6 reports the results. Section 7 summarizes the results and

concludes.

2. LITERATURE REVIEW

2.1. Bank Loans and Firm Activities. There is a vast literature that examines empirically

the effects of bank lending on the real economy. In his seminal paper, Bernanke (1983), using

aggregate data, claimed to show that bank failures significantly reduced aggregate production

in the U.S. economy during the Great Depression. His study, however, has been challenged on

the grounds that it does not identify loan supply shocks as distinct from shocks to loan demand.

In other words, the observed relationship between bank failures and aggregate production may

simply capture the fact that the recession caused bank failures. In fact, using U.S. state-level data

for the 1990–91 recession, Bernanke and Lown (1991) find no significant relationship between

bank lending and employment growth when loan growth is instrumented for by banks’ capital–

asset ratio, suggesting that a credit crunch was not a major cause of the 1990–91 recession.4

Another approach to examine the issue has been the use of event studies to investigate

the effect of bank failures on the market values of client firms. The first study to employ this

approach was Slovin et al. (1993), which analyzes the stock prices of firms that had a lending

relationship with Continental Illinois National Bank during the period of its de facto failure.

This study was followed by Yamori and Murakami (1999), Bae et al. (2002), and Brewer et al.

(2003a), all of which find a significant effect of bank failures on the market values of firms that

had borrowed from those banks.5,6

The advantage of these event studies is that they are able to clearly identify bank failure

shocks using high-frequency (daily) data. However, they have limitations as well. First, event

studies rely on the assumptions of market efficiency and rational investor behavior. Second,

event studies cannot be applied to nonlisted firms. In this article, we focus on real firm activity,

namely, investment behavior, and hence do not require any assumptions of market efficiency or

rationality. In addition, our analysis includes many unlisted firms, most of which are small and

medium-sized, and therefore are likely to be affected severely by a shock to their lender banks.

Several other studies use firms’ financial statements to investigate the effects of bank fail-

ures or weak bank health on client firms.7For instance, Hori (2005) examines the profitability

of firms that borrowed from a large failed Japanese bank (Hokkaido-Takushoku Bank) and

finds adverse effects on firms with low credit ratings. Similarly, Minamihashi (2011) analyzes

the failure of two long-term credit banks in Japan and finds that the failures significantly de-

creased client firms’ investment. Fukuda and Koibuchi (2007) examine client firms’ profitability

subsequent to the failure of the two long-term credit banks in Japan. Finally, Gibson (1995,

4More recently, using quarterly data collected from the CRSP/Compustat Merged (CCM) Fundamentals Quarterly

database for 1983–2010, Kahle and Stulz (2013) examine whether during the recent financial crisis in the United States,

the associated shock to bank lending led to a reduction in capital expenditures but found no evidence to support this

hypothesis.

5Note, however, that Brewer et al. (2003a) also find that the magnitude of these negative effects on the value of

borrower firms is not significantly different from that on all other firms in their sample.

6Some studies examine the effects of bank failure on the stock returns of survivor banks. For example, Yamori

(1999), investigating the effect of the failure of a regional bank in Japan (Hyogo Bank) on the subsequent returns on

the stocks of other banks, finds that the returns on the stocks of problem banks were significantly lower than those of

solvent banks. Brewer et al. (2003b) also examine the response in equity returns of Japanese banks to the failure of four

commercial banks and two securities firms between 1995 and 1998 and find that the share prices of surviving banks on

the whole responded unfavorably to the failures and that financially weaker survivors were more adversely affected.

7There is a related strand of literature that examines the effects of shocks to bank balance sheets on bank lending.

For example, using bank balance sheet data, Woo (2003) and Watanabe (2007) find that weakly capitalized Japanese

banks reduced their lending in 1997, when the Ministry of Finance started to impose rigorous self-assessments of loan

classifications.