The underinvestment problem and patterns in bank lending

Financial theory suggests that leverage causes firms to underinvest and tha t the extent of underinvestment is related to the degree of financial lever age. This prediction is consistent with both time series and cross-sectiona l patterns in bank lending. Bank capital typically declines in recessions d ue to loan losses, and this effectively increases financial leverage. As a result, system-wide underinvestment by banks is a contributing factor in "c redit crunches." In the cross section, banks with relatively poor loan qual ity, capital, and/or liquidity and weak banks with more opportunities subje ct to underinvestment should and do experience lower loan growth. Cross-sec tional differences in the use of subordinated debt and in the extent of sec uritization provide additional evidence in support of the underinvestment h ypothesis. Journal of Economic Literature Classification Numbers: E51, G21. (C) 1998 Academic Press.