Firm debt financing structures and the transmission of shocks in the euro area

Prepared by Fédéric Holm-Hadulla, Alberto Musso, Giulio Nicoletti and Mika Tujula

Published as part of the ECB Economic Bulletin, Issue 4/2022.

1 Introduction

The debt financing structure of euro area firms has broadened since the introduction of the euro as the common currency. While bank loans still account for a major share of corporate debt, euro area firms have increasingly resorted to bond financing, especially following the global financial crisis (GFC) of 2008-09.^[1] As a result, the outstanding volume of bonds relative to bank borrowing by euro area firms has risen to around 30%, up from roughly 15% in mid-2008.^[2] Corporate bond markets have therefore emerged as an increasingly significant determinant of euro area credit conditions over the past decade and a half.

The rise in bond financing has continued during the coronavirus (COVID-19) pandemic, albeit reflecting different drivers than during the GFC and its aftermath. Amid acute vulnerabilities across the banking sector, loan supply contracted in the wake of the GFC (Section 2). This forced firms to turn to bond markets as a substitute source of credit, despite the higher relative cost at that time.^[3] During the pandemic, firms instead benefited from more favourable loan supply conditions than during the GFC. This was because (1) banks entered the pandemic with significantly stronger balance sheets, in part owing to the regulatory overhaul of the preceding decade, and (2) bank intermediation capacity was underpinned by a swift and extensive fiscal, supervisory and monetary policy response.^[4] As these factors supported large loan flows at favourable conditions throughout the pandemic, the concurrent expansion of bond finance has complemented, rather than replaced, bank lending. In this regard, bond finance has also benefited from both the monetary policy support directed at bond markets over recent years (Section 3) and the supply of credit from non-bank financial intermediaries (Boxes 1 and 2).

The evidence presented in this article indicates that firms’ debt financing structures also matter for the transmission of shocks to the economy. Patterns derived from an econometric model suggest that loans and bonds in the euro area both expand in response to an exogenous increase in business investment, which may materialise, for instance, if the recovery were to unexpectedly speed up (Section 4). On the other hand, when the euro area economy experiences adverse aggregate supply shocks, historical regularities indicate that corporate bond issuance tends to cushion the resulting credit contraction, in turn supporting economic resilience.

Moreover, the increased role of bond financing also shapes the transmission of monetary policy. The aforementioned econometric model suggests that bond finance in the euro area partly counteracts the bank lending channel while reinforcing other channels that operate via broader financial market conditions (Section 4). The transmission of monetary policy measures primarily affecting short-term interest rates is therefore stronger in euro area countries with a lower share of bond finance. By contrast, measures that chiefly affect long-term interest rates, and are thus concentrated in maturity segments that carry the bulk of corporate bond issuance, are subject to stronger transmission in countries with a higher share of bond finance. A given set of policy measures may therefore have diverse economic effects in different parts of the euro area.

In addition to the shift in aggregate debt structures, the changing composition of corporate bond markets may affect transmission and firms’ resilience to shocks. The increased dependence of euro area firms on bond markets has not been limited to the historically largest issuers; it has also been driven by firms that have recently entered the bond market for the first time. This has led to a shift in the composition of bond issuers towards smaller and riskier firms (Box 1). The resulting diversification away from a predominantly bank-based debt structure may strengthen firms’ resilience to crises that chiefly affect this part of the financial sector. Moreover, access to bond markets does not seem to systematically induce firms to increase their leverage (Box 2). This is reassuring in terms of firms’ financial resilience, as debt overhang problems in the corporate sector may depress investment, employment and GDP. At the same time, the increased presence of more vulnerable firms in bond markets may expose the corporate sector to broader financial market turmoil, thus posing potential challenges for monetary policy transmission.

2 A tale of two crises

Since the onset of the pandemic, corporate bond markets have acted as a major complement to bank-based borrowing by euro area firms. Corporate bond market conditions deteriorated sharply during the financial turmoil in late February and early March 2020, triggered by the rapid increase in COVID-19 cases in Europe. After the adoption of the ECB’s pandemic emergency purchase programme (PEPP) on 18 March 2020, euro area corporate bond prices and issuance recovered (see below). By the end of 2021 the outstanding amount of euro area corporate bonds stood more than €200 billion above its pre-pandemic level (Chart 1, panel a). This expansion has been broad-based across the larger euro area countries. While France, with its historically high share of bond finance, accounted for the bulk of the increased issuance, Spain, Germany and Italy also recorded strong positive flows. In the latter three countries, the proportion of bond finance in the additional debt taken up by firms during the pandemic actually exceeded by a considerable margin the amount needed to stabilise the bond share in the stock of debt at pre-crisis levels (Chart 1, panel b). As such, the secular rise in bond finance as a share of corporate debt has persisted during the pandemic crisis and added to its relevance for overall credit conditions in the euro area.^[5]

The complementary role of market and bank-based debt during the pandemic stands in contrast to the patterns observed during the GFC, when bond finance acted as a substitute for bank loans. While both crises were followed by similar upward trends in bond financing volumes, the bank lending dynamics pointed in opposite directions. In contrast to their record expansion during the pandemic crisis, corporate loans overall contracted in the one-and-a-half years following the collapse of Lehman Brothers (Chart 1, panel a). This contrasting picture is consistent with the different loan supply conditions that prevailed in the respective crises. Amidst an urgent need for bank balance sheet repair and subsequent regulatory tightening, loan supply contracted sharply during the GFC (Chart 2).^[6] This in turn forced firms with access to bond markets to resort to this alternative source of debt finance, notwithstanding its high relative cost at the time (Chart 3, panel a). Moreover, the reduction in loan supply led many of the entirely bank-dependent firms to be shut off from external financing, which reinforced the contractionary impact of the GFC on their business activity. However, during the pandemic crisis banks benefited from their previous efforts to repair their balance sheets, accompanied by a strengthening of the euro area regulatory and supervisory framework, and from the broad-based policy response to protect credit supply. This enabled them to deploy their lending capacity as a backstop to the corporate sector, resulting in much more benign loan supply conditions (Chart 3, panel b). Therefore, the expansion of corporate bond finance during the pandemic crisis has not resulted from necessity, but from firms choosing to capitalise on the favourable cost of corporate bond finance over that period (Chart 3, panel b).^[7]

Chart 1

Euro area loans to non-financial corporations (NFCs) and corporate debt securities issuance during the GFC and the pandemic crisis

a) Euro area flows during the GFC (left panel) and pandemic crisis (right panel)

(cumulative monthly flows, EUR billions)

b) Share of corporate debt securities and loans across euro area countries during the pandemic crisis

(percentages)

Chart 2

Loan supply and the relative role of market-based debt financing

(left-hand scale: bond share percentage changes, right-hand scale: lagged loan supply indicator changes; an increase in the loan supply indicator (LSI) represents a tightening of loan supply)

Chart 3

The ratio of debt securities to loans and the relative cost of market and bank-based debt

(left-hand scale: cumulative changes; right-hand scale: ratio based on notional stocks; percentage points)

The different motives driving the financing decisions of firms during the two crises are also reflected in firm-level data. Both crises exerted heterogeneous effects on the performance of individual firms, as measured, for instance, by sales growth (Chart 4). While the bulk of firms suffered a contraction, some weathered the crises better or even improved their performance.^[8] As a result, a distinction can be made between hard-hit firms whose borrowing decisions were dictated by the need to satisfy emergency liquidity needs, and less-affected firms whose borrowing decisions remained predicated on the relative attractiveness of different debt instruments. This distinction subsequently manifested itself in opposing relationships between firm performance and debt financing structures during the two crises (Chart 4). During the GFC, even hard-hit firms increased their relative reliance on bond finance to sustain their emergency needs for credit against the backdrop of tight loan supply constraints (orange line in Chart 4). During the pandemic, however, hard-hit firms were able to rely on bank lending as a safety net, whereas less-affected firms could draw on bond finance to benefit from its favourable relative cost (blue line in Chart 4).

Chart 4

Firm performance and financing structure during the GFC and pandemic crises

(x-axis: sales growth, percentage points; y-axis: bond share yearly changes, percentage points)

Box 1
Examining the rise of bond financing in the euro area

Prepared by Melina Papoutsi^[9]

This box examines the growth of bond financing in the euro area through the lens of a cross-section of corporate issuers. Over the past two decades several macroeconomic trends have driven the rise of bond financing in Europe. These include the fall in bank loan supply, the implementation of tighter regulation, accommodative monetary policy that compresses bond yields (including via the ECB’s corporate sector purchase programme), legislation supporting the issuance of corporate bonds by medium-sized firms in some euro area countries and bankruptcy reforms.^[10] While the aggregate growth in bond financing is well known, the same cannot be said about its cross-sectional implications. In the past, the European bond market included only the largest firms. This box highlights new microdata that are used to examine the growth of the bond market over the past two decades and answers three questions. First, is the increase in bond financing concentrated in historical issuers or are new firms entering the market? Second, what types of issuer are driving the extensive growth margin? Third, which investors are supplying the additional credit provided via corporate bond markets?

The increase in firms’ dependence on the bond market is not restricted to the largest historical issuers; it is also driven by firms that have entered the bond market for the first time in the last 15 years. Their entry has led to a shift in the composition of bond issuers towards smaller and riskier firms. Trends in credit ratings show that the volume of BBB securities has been rising fast and has outgrown the rest of the investment grade category. However, looking solely at credit ratings underestimates the underlying shift in risk for two reasons. First, coverage by rating agencies in the euro area is low, with less than 15% of new bond issuers being assigned a rating. Second, new issuers with a rating are significantly larger and more profitable than new issuers without one. Thus, it is necessary to link bond issuance with firms’ characteristics to achieve a more comprehensive analysis of issuer risk in the euro area.

Compared with historical issuers that already had outstanding bonds in 2003, new issuers are significantly smaller, less profitable and have higher levels of leverage.^[11] This is particularly pronounced for listed issuers, which have multiplied in recent years. Chart A compares the characteristics of new issuers with those of historical issuers and non-issuers over our sample period, including non-listed firms. Data on three characteristics – size, leverage and profitability – can be computed even for unrated firms. Panel a) illustrates how new issuers are noticeably smaller than historical issuers. The left-hand chart in panel b) highlights that new issuers had substantial amounts of debt throughout the sample period. According to the right-hand chart in panel b), new issuers are less profitable than historical issuers. These patterns are particularly striking for non-listed issuers, which tend to be much smaller, less profitable and have higher leverage than listed issuers.

Chart A

Size, leverage and profitability of different types of firm

a) Total assets

b) Leverage and EBITDA over assets

In order to determine the economic implications for bond market growth, it is necessary to ask how investor composition varies across different types of issuer. The risk of a sudden deterioration in lenders’ supply of funds in times of financial hardship is of significant concern to credit markets. While traditional “buy-and-hold” bond investors (such as pension funds and insurance corporations) look to the long term, bond funds have been growing extensively in recent decades. In times of hardship, the latter can become a source of fire sales and price dislocations.^[12]

Chart B

Investor composition – non-financial issuers in 2019

(percentages)

Holdings of stable “buy-and-hold” bond investors are large in aggregate but small for weaker issuers. Chart B presents the investor composition at the end of 2019 for all corporate bonds issued by all non-financial euro area issuers in panel a) and by non-financial euro area issuers of different size in panel b). Comparing the two reveals the following. First, the investor composition of the largest issuers is similar to the aggregate. However, the investor composition of smaller private issuers is noticeably different. The share of “buy-and-hold” investors (for example, the Eurosystem, insurance corporations and pension funds) is only 5%, or roughly 20 percentage points lower than in aggregate. Long-term investors’ mandates limit their exposure to risk and can systematically exclude new issuers because of their bond size or rating status. Second, we see higher shares of holdings by households (14% compared with 3%) and by banks (over 40% compared with 9%). For small issuers, bond holdings are highly concentrated in the banking sector, implying a high degree of exposure to banking shocks. These facts suggest that firm-investor matching occurs.

Overall, the landscape of corporate debt financing has changed significantly over the past 15 years, with many more firms exposed to market fluctuations. Firms’ increased access to credit and their reduced reliance on the banking sector is well documented. However, the impacts of this shift on financial stability and potential interactions with regulation are yet to be fully understood. The evidence of heterogenous bond investor composition across different types of issuer is a first step towards building a more comprehensive framework around bond credit supply and its macroeconomic implications. Further analysis is needed to better understand the welfare and policy implications of this shift in corporate debt financing.

3 Monetary policy and firm financing flows

Empirical evidence suggests that monetary policy was a key driver behind the differences in firm financing flows between the two crises. In addition to the differing nature of the two crises, the monetary policy response differed in terms of speed and strength during the GFC compared with during the pandemic. The following analysis seeks to assess whether these differences in monetary policy have also contributed to the differential patterns in bond financing flows. The analysis is based on a medium-scale BVAR with sign restrictions to identify multiple financial, real and monetary policy shocks.^[13] Based on a historical decomposition, this model is used to quantify the contribution of each identified shock to real NFC loan and bond growth (Chart 5). The analysis indicates that monetary policy was a key factor distinguishing the two crises. While monetary policy also supported bond financing flows during the GFC, its positive contribution was almost twice as high and markedly more persistent during the pandemic. These results are also consistent with the specific design of the policy response, which during the pandemic – unlike during the GFC – also comprised central bank asset purchases that provided more direct support to corporate bond markets than standard policy rate cuts would have done.^[14]

Chart 5

Monetary policy’s contribution to growth in NFC debt instruments during the two crises

(percentage points)

Besides injecting additional accommodation, monetary policy also supported corporate bond markets by preventing a prolonged period of financial market turmoil. As the pandemic reached Europe in late February 2020, the risk-off mode in financial markets triggered a sharp sell-off in the euro area corporate bond market, with spreads nearly doubling in around two weeks. With the announcement of the PEPP on 18 March 2020, the rising pressure on corporate bonds subsided quickly, while equity prices also recovered (Chart 6). The PEPP’s role in safeguarding transmission was therefore instrumental in enabling corporate bond markets to complement the backstop provided by bank lending to firms.^[15] Moreover, this stabilising effect on the market was later reinforced by further changes to monetary policy, such as the expansion of the PEPP in June 2020.^[16]

Chart 6

Corporate bond spread and stock market reactions around PEPP announcements

(x-axis: changes in investment-grade bond spreads relative to the overnight index swap (OIS) rate in basis points; y-axis: percentage changes in stock prices)

4 Implications for the transmission of shocks

The continued shift towards market-based finance may alter the transmission of key macroeconomic forces. Bank loans are typically easier to adjust in response to unexpected changes in the economic landscape, whereas corporate bonds benefit from a more diversified creditor base and a longer maturity than bank lending to firms.^[17] These differences may impinge on the direction, strength and speed with which the debt instruments respond to economic shocks. But empirical evidence testing this hypothesis is scarce, and it therefore warrants further analysis. Among the many shocks that may hit the euro area economy at any given point in time, two appear particularly relevant in the current circumstances. The first is a positive demand shock originating in firms’ increased business investment activity in response to an accelerating recovery from the pandemic. The second is an adverse aggregate supply shock, which could stem, for instance, from further intensification of global supply and transport bottlenecks, as well as from commodity market fluctuations similar to those observed since the onset of the war in Ukraine.

Corporate bond financing complements bank lending when it comes to responding to positive business investment shocks, whereas it temporarily dampens credit contraction after adverse aggregate supply shocks. This analysis is again centred on the empirical framework underlying Chart 5 and uses sign restrictions to distinguish between different types of shocks. It focuses on a positive demand shock arising from a pick-up in business investment and on an adverse aggregate supply shock.^[18] The estimates show that bank lending and bond issuance both expand after positive business investment shocks, and the timing and size of the effects on both are very similar (Chart 7, panel a). By contrast, negative aggregate supply shocks initially trigger offsetting adjustments in loan and bond finance: loans immediately enter on a contractionary path, whereas bond issuance expands in the first two quarters after the shock (Chart 7, panel b).^[19] This dampening effect of bond finance becomes insignificant after that horizon, but its subsequent downward adjustment is also moderate and statistically indistinguishable from zero. As a result, the overall contraction in credit is less pronounced in the presence of bond markets as an alternative source of finance than if firms were only able to draw on bank loans to finance their debts.^[20] A possible interpretation of these findings is that, in response to an accelerating recovery driven by expanding business investment, firms prefer to diversify their sources of financing for new investment projects, thus resorting to both bank borrowing and bond issuance. By contrast, after an adverse supply shock, banks swiftly restrict their sources of new lending given the worsened economic outlook, forcing firms to mainly tap into broader capital markets to access external financing.^[21]

Chart 7

Responses of NFC loan and bond financing flows to macroeconomic shocks

(x-axis: quarters; y-axis: percentage median and 68th confidence sets)

Lastly, debt financing structures also alter the relative strength of different monetary policy transmission channels. As corporate bond markets offer an alternative source of debt finance, they may counteract policy-induced shifts in loan supply arising from the bank lending channel of transmission. However, bond finance may be more responsive to other transmission channels, for instance owing to the impact of monetary policy on the medium to longer-term segments of the yield curve, where the bulk of corporate bond issuance takes place. Local projections based on a panel of euro area countries confirm this hypothesis.^[22] In countries with a high bond financing share, the corporate sector responds to a standard monetary policy shock by further tilting its debt structure towards bonds, the supply of which (and hence the costs) are less responsive to the shock than those of loans. In countries with an average or lower share of bond finance, this substitution does not take place, so they also exhibit stronger transmission of short-rate shocks to the real economy (Chart 8). The pattern is reversed for policy-induced increases in long-term rates, which are followed by a stronger relative contraction in bond finance, eventually translating into a stronger impact on GDP.^[23]

A given set of policies may therefore exert diverse economic effects on different parts of the euro area. While specific monetary policy measures tend to intervene on different yield curve segments simultaneously, the impact of policy-rate changes (asset purchases) tends to concentrate in the front end (back end) of the yield curve. Hence, policy rate changes (asset purchases) are likely to exert stronger financial and real effects in euro area countries with a low (high) share of bond finance.

Chart 8

Response of GDP to long-rate and short-rate monetary policy tightening shocks

(percentages)

Box 2
Market-based finance for corporations – the demand for and supply of credit

Prepared by Margherita Giuzio and Francesca Lenoci

The rise in euro area corporate bond issuance documented in Section 1 has been driven by both demand and supply factors. On the one hand, the demand for market-based credit from firms was stimulated by the reduced cost of market-based debt relative to loan rates, the ECB’s asset purchases and corporate sector purchase programme, as well as the need to diversify funding sources following the global financial crisis (GFC).^[24] On the other hand, the growth of non-banks, which hold over 50% of outstanding euro area corporate bonds, increased the supply of credit from the market, further incentivising firms to issue bonds. At the same time, stricter regulation of banks dampened the bank lending supply, especially to riskier firms.^[25]

As loans and bonds are not perfect substitutes, firms’ incentives to use bond financing vary with their balance sheet characteristics, the structure of capital markets and the cost of alternative funding sources.^[26] Empirical evidence based on a sample of large euro area non-financial corporations (NFCs) between 2014 and 2019 shows that NFCs issuing bonds are on average larger, more leveraged and have a lending relationship with a larger number of banks (Chart A). Also, firms are more likely to tap into the market if they have issued bonds in the past, if the average guarantee provided by the underwriters at issuance is larger and if the supply of credit from connected banks is lower. Moreover, bond issuance is more likely if the firm-specific cost of loans relative to bond financing rises.

Chart A

Differences between NFCs issuing bonds and NFCs financed only by banks

(left-hand scale: Q4 2014 – Q3 2019, log of total assets; right-hand scale: percentages)

A comparison of firms with a similar probability of issuing bonds using propensity score matching suggests that credit cost is not the only driver of bond issuance.^[27] Greater market supply – as measured by the average share of issuance guaranteed by underwriters – stimulates issuance, especially by firms with a low probability of issuing bonds ex ante. By contrast, when bank lending is constrained, firms with a high probability of issuing bonds tend to replace bank credit with market-based finance. And, when bank lending increases, they resort to both sources of financing.

The growing supply of credit from the market, in particular from non-banks, has positive effects on economic growth, as it facilitates the efficient allocation of capital and provides firms with an alternative credit source to finance new investments.^[28] It may, however, also introduce new sources of volatility to the economic cycle and contribute to increasing corporate leverage, thus exacerbating the vulnerabilities of highly indebted firms. While banking regulation seeks to limit excessive credit supply, credit from non-banks lacks this sort of shock absorption mechanism. For this reason, it is important to assess whether bond issuance adds to bank credit in a way that increases firms’ leverage, or whether it is instead a substitute for bank loans.

For the sample of euro area firms that issued bonds between the first quarter of 2014 and the third quarter of 2019, empirical evidence suggests that bond issuance has replaced bank financing. Estimating the joint effect of bond issuance on firms’ size, leverage and financing structure allows the complementary or substitutive relationship between the two funding sources to be tested. If firms collectively experience an increase in size and leverage and a reduction in loan financing over total debt after issuing bonds, then this has increased their balance-sheets, thus complementing bank loans. By contrast, if firms’ size and leverage do not change, and the financing structure shifts towards bond financing, then the latter has replaced bank lending. The regression results in Table A show that bond issuance has not altered firms’ size and leverage but has replaced bank financing.^[29] The shift towards market-based finance is, however, not homogeneous across countries and firms of different sizes. This may influence the transmission of monetary policy when it comes to the cost and volumes of financing, which has financial stability implications related to market fragmentation in credit provision.

Table A

Estimated impact of new credit on firms’ assets, leverage and financing structure

(Q4 2014 – Q3 2019, coefficient estimates)

5 Conclusion

This article has reviewed the evolution of firm financing structures in the euro area and the implications for macroeconomic shock transmission. The share of bonds in euro area corporate debt has risen, in particular since the GFC, and this trend has persisted through the ongoing pandemic crisis. However, the motives for firms to access bond markets have differed across these crises. During the GFC, firms accessed bond markets as a substitute for falling loan supply. However, during the pandemic crisis, they did so as a result of the favourable relative cost of bond financing, amid a supportive monetary policy environment, which also comprised measures directly targeted at fostering credit supply from corporate bond markets. As such, monetary policy effects have materialised alongside certain longer-term structural drivers of the increased reliance by firms on bond markets. These drivers include, for example, the growing footprint of non-bank financial intermediaries, which supply the bulk of credit in this market.^[30] Moreover, drivers include the strengthened prudential landscape in which banks operate, which has an influence on loan market conditions.^[31]

The rise of bond finance has significant consequences for the transmission of shocks to the euro area economy. Based on an empirical analysis of aggregate data, this article has highlighted the varying responses of different debt financing instruments to specific macroeconomic shocks: while accelerating business investment demand triggers qualitatively similar adjustments in bond and loan volumes, bond issuance mildly cushions the credit contraction after adverse supply shocks. Moreover, a higher share of bond financing strengthens the transmission of monetary policy measures that primarily operate via longer-term yields, whereas short-term rate changes tend to exert stronger real effects in economies that are more dependent on loans.

There is substantial scope for further analysis of the mechanisms underlying these stylised macroeconomic facts. The literature on firm financing structures and shock transmission is still nascent, in particular for the euro area. Complementary analysis drawing on firm-level data and linking the supply and demand sides of corporate bond and loan markets appears to be a particularly promising avenue to gather additional insight into the matters addressed in this article.

The change in firm financing structures may also have broader implications for the strength and resilience of the euro area corporate sector. As this sector has partly diversified away from bank loans, it may become more resilient to crises concentrated in the banking sector. In addition to this benefit at the aggregate level, the incidence of such crises also becomes less heterogeneous as more small and medium-sized firms move away from being solely reliant on bank loans and are instead gaining access to bond markets as a cushion. However, this beneficial diversification effect may be counteracted by other risks and sources of volatility across the economic cycle. Most notably, it is primarily non-bank financial intermediaries that provide credit to firms via bond markets. Structural vulnerabilities and shocks that impair their ability to provide credit can negatively affect NFC funding costs. Also, as some of the non-bank intermediary sectors are subject to less stringent regulatory and prudential frameworks, these may face weaker constraints on engaging in excessive risk-taking behaviour. In addition to the resulting risks to financial resilience and capital misallocation, more leveraged firms have increasingly started to access euro area bond markets over recent decades. Against this backdrop, there is a case for enhancing the regulatory framework for non-banks – including from a macroprudential perspective – to support financial stability and the smooth transmission of monetary policy.