Connecting borrowers and lenders can involve a long chain of financial intermediaries. While these go-betweens can benefit the broader economy by smoothing the flow of credit, there are now probably too many links in the credit chain, argue Chicago Booth’s Zhiguo He and Columbia’s Jian Li (a graduate of Booth’s PhD Program). A shorter chain could reduce both borrowing costs and overall financial risk, they suggest.
Rather than quantify the optimal number of intermediaries, the researchers developed a holistic framework for modeling the entire credit chain. This approach, they suggest, could help regulators target policies that promote overall access to capital while avoiding dangerous credit bubbles, such as the one that triggered the 2008–09 financial crisis.
Suppose a small manufacturer takes out a six-month loan, but when that debt comes due, the economy has soured and the company is hurting for cash. Worse, it can’t find a new lender to pay off its old loan. Strapped, the company is forced to unload its factory buildings, inventories, and other assets at deep discounts, potentially leaving its creditor with pennies on the dollar.
In recent years, a slew of “shadow banks” has sprung up to address this problem. Today, instead of borrowing directly from a lender, the same manufacturer might borrow from an investment fund for one year, while the fund itself borrows for just six months. If half a year later the fund can’t refinance its own debt, it, too, might have to sell assets, including its loan to the small manufacturer.
This six-month maturity mismatch creates a cushion in the credit chain, the researchers argue. That’s because there’s a chance that sales improve and the manufacturer pays off most or all of its debt—implying that the investment fund would take a smaller haircut on the one-year loan than the manufacturer would take by dumping its factories under duress after six months.