Long-term interest rates and bank loan supply: Evidence from firm-bank loan-level data

This paper examines the effects of long-term interest rates on bank loan supply. Using a simple mean-variance model of bank portfolio selection subject to the value-at-risk (VaR) constraint, we make theoretical predictions on two transmission channels through which lower long-term interest rates increase loan supply: (i) the portfolio balance channel and (ii) the bank balance sheet channel. We construct a unique and massive firm-bank loan-level panel dataset for Japan spanning the period 2002-2014 and test our theoretical predictions to find the following. First, an unanticipated reduction in long-term interest rates increased bank loan supply, which lends support to the existence of the portfolio balance channel. Second, banks that enjoyed larger capital gains on their bond holdings due to a decline in interest rates significantly increased their loan supply, which lends support to the existence of the bank balance sheet channel. Further, the bank balance sheet channel was stronger in the case of loans to smaller, more leveraged, and less creditworthy firms, which suggests that a stronger balance sheet leads banks to increase their loan supply to credit-constrained and riskier firms.