Consequences of a Credit Crunch on Firm Financial Policy, Investment, and Risk Premia

Consistent with precautionary savings models, we show evidence that firms hoard cash in response to an exogenous increase in the cost of bank financing. For identification, we compare public U.S. firms in the same industry, location, and size quintile, but whose main lenders’ credit supplies are differentially affected by the WorldCom demise in 2002. The credit supply shock induces a transitory decline in investment, and a permanent increase in the likelihood of extreme negative cash flow realizations. Firm betas also increase after the supply shock, suggesting that financing constraints affect firm valuation by increasing the risk premium.