Lending Effi ciency Shocks

This paper develops a theory in which shocks to the effi ciency of information acquisition by financial intermediation translate into business cycle fluctuations via capital reallocation. In our theory, under costly verification, the bank chooses to only monitor the returns of those entrepreneurs with insuffi cient net worth. This distorts the existing capital allocation among entrepreneurs of different sizes. A crucial ingredient of the model is that the outcome of monitoring is random and depends on both the effi ciency of monitoring and the resources devoted to policing the returns of a project. As a consequence, a negative shock to monitoring effi ciency forces bank to increase monitoring intensity and reduce the loan toward small entrepreneurs. This results in an increase in productivity dispersion and a recession. Using the COMPUSTAT dataset, we find a significant countercyclical pattern for the relative capital productivity of small to large firms, and a procyclical capital allocation between them. Such an empirical observation distinguishes the lending effi ciency shocks from other aggregate shocks as the sources of business cycles. JEL Classification: E32, G34