Below Kaoru Hosono and Daisuke Miyakawa examine the impacts of financial shocks arising from two earthquakes in Japan on firms’ financing and activities. On one hand, they find that bank damages from the 1995 Kobe earthquake significantly lowered the investment and export of undamaged firms transacting with damaged banks. On the other hand, they find that bank damages from the 2011 Tohoku earthquake did not affect bank borrowing, even reduced the probability of firms’ bankruptcy, and further weakened the tendency for more efficient firms to be less likely to go bankrupt. Their results suggest temporary and modest government support after a disaster is desirable.
Direct and Indirect Impacts of Natural Disasters
Natural disasters disrupt business operations not only directly through the loss of lives and the destruction of buildings and equipment, but also indirectly through the impact on firms’ transaction partners. A survey conducted in July 2012 following the Tohoku earthquake, which wreaked havoc in the northern part of Japan on March 11, 2011, for example, suggests that 62.5% of firms in the Tohoku area suffered direct damage from the earthquake. In addition, however, 36.5% of firms also indicated that they were negatively affected by damage to their suppliers, and 44% stated that they were negatively affected by damage to their customers. Moreover, 4.8% of firms replied that they were adversely affected by the fact that the bank with which they transacted suffered damage as a result of the earthquake.
Among firms’ transaction partners, suppliers of funding, especially banks, play a particularly important role in the process of economic recovery from natural disasters. When banks suffer physical damage or damage to their capital as a result of a natural disaster, they may not be able to provide sufficient funds at the same interest rates as before. In frictionless financial markets, firms should be able to offset such a negative shock to their funding by switching from a damaged to an undamaged bank or raising funds from the financial markets. In practice, however, switching may involve substantial costs or time due to the role played by private information on firms’ creditworthiness, potentially making it difficult for firms to obtain funds from alternative sources in a timely and cost-efficient manner. Thus, whether damage to banks affects firm activities or not is an empirical issue.
Nonetheless, there are relatively few studies that examine how impairment of banks’ functioning in the wake of a natural disaster affects firm’s activities. Against this background, this article shows how damage to banks affects firms’ financing and activities such as capital investment, exports, and bankruptcy based on the results of the studies we conducted on Japan’s 1995 Kobe earthquake and 2011 Tohoku earthquake. Before going into details of our studies, it is noteworthy that while government supports were limited to damaged firms at the time of the Kobe earthquake, they were largely extended to damaged banks in the case of the Tohoku earthquake, suggesting that damages to banks may have different impacts on firms between the two earthquakes.
Empirical Strategy to Study Financial Constraints
Damage to banks is likely to undermine their lending capacity and to tighten the financial constraints that firms face when they undertake capital investment1 or start exports.2,3 Due to such financial constraints, firms may not be able to finance capital investment or the fixed costs associated with entering a foreign market (for example the costs of building a sales network abroad and adapting products to local tastes and regulations). Financial constraints may also restrict the volume of exports of firms that have already started exporting due to a reduction in the amount of trade finance.
Although the theoretical predictions on the relationship between financial constraints and firm activities are straightforward, empirically examining this relationship is fraught with difficulties due to identification problems. That is, not only may lending by banks affect the performance of borrowing firms, but also borrowing firms’ performance may have a significant impact on lenders’ financial health and thus their lending. Furthermore, there may be assortative matching between firms and banks.4 Specifically, better-performing firms may be more likely to transact with better-performing banks. Both of these issues mean that it is difficult to clearly identify the direction of causality between bank lending and firm performance.
Against this background, two studies by a team of researchers of which we are members,5,6 investigated the effects of bank damage due to a natural disaster on borrowing firms’ capital investment and export behavior. In order to circumvent the identification problems indicated above, the studies took advantage of the natural experiment provided by the 1995 Kobe earthquake. Devastating natural disasters such as the Kobe earthquake are likely to impose significant financial constraints on firms through the exogenous financial shock caused by the reduced lending capacity of banks from which firms borrow. For example, a natural disaster may obliterate information on borrowers’ creditworthiness accumulated at the disaster-hit banks and thus destroy their managerial capacity to originate loans, including the ability to screen and process loan applications. Natural disasters may also cause damage to borrowing firms located in the disaster-hit areas, which may lead to a deterioration in banks’ loan portfolios and hence weaken their risk-taking capacity.
To separate out the purely exogenous shock to firms’ financing stemming from the reduced lending capacity of banks, in the two studies mentioned above, we specifically focused on firms that did not suffer any direct damage of their own as a result of the disaster but that were borrowing from damaged banks. If we focused on firms that suffered any direct damage of their own, our analysis would suffer from the identification problem described above, since any reduction in such firms’ capital investment or exports might reflect that they lost pledgeable assets or could not produce goods to export rather than the effect of financial constraints due to damage to their banks. Employing this approach also circumvents any potential problem caused by positive assortative matching, since it would be implausible to assume that better-performing firms choose banks that are less likely to be hit by a natural disaster.7
Evidence on the Effects of Bank Damage from the 1995 Kobe Earthquake on Firm Investment
The first of the studies that we are introducing here, focused on the effects of damage to banks on firms’ investment activity.8 In the study, two alternative definitions of bank damage were used: (a) damage to a bank’s headquarters, which is a dummy that takes one if the bank was headquartered in the earthquake-hit area and aims to capture the decline in the bank’s managerial capacity to process loan applications at the back office, and (b) damage to a bank’s branch network, which is the ratio of the number of branch offices located inside the earthquake-affected area to the total number of branches and aims to capture the decline in the bank’s financial health and risk-taking capacity. The results show that firms located outside the earthquake-affected area but associated with a main bank located inside the area have a significantly lower investment-to-capital ratio than firms outside the affected area associated with a main bank that was also located outside the area, indicating that bank damage has a negative impact on firm investment. Moreover, this negative impact is not only statistically significant, but also economically significant. For example, in the case that bank damage is defined as damage to banks’ headquarters, the investment ratio of undamaged firms whose main bank was damaged is 8.2 percentage points lower than that of undamaged firms whose main bank was not damaged. This impact is economically significant, given that the average investment ratio for undamaged firms in FY1995 was 13.1%.
Evidence on the Effects of Bank Damage from the 1995 Kobe Earthquake on Firm Exports
The second study, by Miyakawa et al.,9 examined the effects of damage to banks on firm exports. Specifically, like the first, the study focused on firms that were located outside the area affected by the 1995 Kobe earthquake and that were hence undamaged, and divided these firms into those whose main bank was located within the affected area and was damaged, and those whose main bank was not located in the affect area. The results of the study can be summarised as follows. First, as for the extensive margin of exports, we found that firms whose main bank is damaged are less likely to start exporting or expand the regions to which they export than firms whose main bank is unaffected. Moreover, the impact of bank damage on undamaged firms is not only statistically but also economically significant. For example, the probability of starting exporting is 4.5 percentage points lower for firms whose main bank is damaged than for firms whose main bank is unaffected. This impact is substantial given that the average probability of starting exports of firms in unaffected areas in FY1995 was 4.4%. The negative impact increases to 6.7 percentage points for FY1996 before declining to 3.3 percentage points for FY1997. This finding suggests that the exogenous damage to banks’ lending capacity has a substantial adverse effect on the extensive margin of firm exports.
Second, as for the intensive margin, we found that firms whose main bank is damaged has a lower export-to-sales ratio than firms whose main bank is unaffected. This finding is consistent with the prediction that the exogenous damage to banks’ lending capacity has an adverse effect on the intensive margin of firm exports through a smaller provision of trade finance. Specifically, we found that in FY1995 the export-to-sales ratio of firms whose main bank was damaged was 6.5 percentage points lower than that of firms whose main bank was unaffected This impact is economically significant, given that the average export-to-sales ratio for firms in the unaffected areas was 9.1% in FY1995.
Empirical Results from the Tohoku Earthquake and Some Lessons from the Two Earthquakes
The results above imply that for economic recovery in the wake of a natural disaster, it is important to ensure that the functioning of financial intermediation is maintained so as to mitigate any potential financial constraints and allow firms to carry on with their capital spending and export plans. To this end, government support provided in the aftermath of the Tohoku earthquake, including capital injection into the banks affected by the earthquake may be justified. Nonetheless, it is also important to note that our findings above indicate that the negative effects of bank damage on firm activities does not last for a long time.10 This means that government measures to intervene in the supply of credit should be timely and terminated within a short period.
As one of our recent research projects focusing on the Tohoku earthquake occurred in 2011, Uchida et al.11 use the data obtained from a firm-level survey conducted in 2012, one year after the Tohoku earthquake, to examine whether firms located in Tohoku area could successfully borrow funds from banks. Employing the data of firms that actually wanted to borrow funds, they examined what type of firms could actually borrow after the earthquake. Their findings are that while damages to the firm had a negative and significant effect on the borrowing probability, damages to the firm’s main bank did not have a significant effect on it. While this result is in contrast with the results from the Kobe earthquake mentioned above, it is natural given that the government effectively recapitalised banks in Tohoku area and the Bank of Japan supplied ample liquidity to them while such public support was not provided after the Kobe earthquake.
Ishinomaki, one of the most damaged Japanese city due to the 2011 tidal wave
Besides the impacts of financial shocks on firms’ financing, Uchida et al.12 also examine the effects originating from bank damage on the probability of firm bankruptcy after the Tohoku earthquake. Using the same data source as in the previous paragraph, they find that a damaged bank in fact reduced, not increased, the probability of bankruptcy and weakened the tendency for more efficient firms to be less likely to go bankrupt. They further examine the impact of the injection of public capital into damaged banks and obtain some evidence that the injection reduces the probability of the bankruptcy of their borrowers and weakens the natural selection. These results confirm the implication mentioned above that while government supports to banks are needed to mitigate the financial shocks arising from a natural disaster, they should be modest and ended in short time periods.
About the Authors
Kaoru Hosono is a professor of Economics at Gakushuin University. He is interested in macroeconomics and finance. He received his PhD in Economics from Hitotsubashi University. His recent studies have been on the effects of natural disasters on firm dynamics including corporate finance, investment, export, entry/exit, and relocation.
Daisuke Miyakawa is an associate professor of Economics at Nihon University. He is interested in corporate finance and firm dynamics. He received his PhD. in Economics from UCLA. His recent studies involve the transmission of unconventional monetary policy, the impacts of the transaction partners’ characteristics on firm dynamics, and the matching mechanism of firms and financial institutions.
1. Kahle, K. and R. Stulz (2013), “Access to Capital, Investment, and the Financial Crisis,” Journal of Financial Economics 110 (2), pp. 280-299.
2. Amiti, M. and D. Weinstein (2011), “Exports and Financial Shocks,” Quarterly Journal of Economics 126 (4), pp. 1841-1877.
3. Paravisini, D., V. Rappoport, P. Schnabl, and D. Wolfenzon (2014), “Dissecting the Effect of Credit Supply on Trade: Evidence from Matched Credit-Export Data,” Review of Economic Studies, forthcoming.
4. Sorensen, M. (2007), “How Smart Is Smart Money? A Two-Sided Matching Model of Venture Capital,” Journal of Finance 62 (6), pp. 2725–2762.
5. Hosono, K., D. Miyakawa, T. Uchino, M. Hazama, A. Ono, H. Uchida, and I. Uesugi (2012), “Natural Disasters, Damage to Banks, and Firm Investment,” RIETI Discussion Paper 12-E-062.
6. Miyakawa, D., K. Hosono, T. Uchino, A. Ono, H. Uchida, and I. Uesugi (2014), “Natural Disasters, Financial Shocks, and Firm Export,” RIETI Discussion Paper 14-E-010.
7. A few exceptional extant studies that deliberately identify loan supply shocks include Amiti and Weinstein (2011, 2013) and Paravisini et al. (2014).
8. Hosono et al. (2012).
9. Miyakawa et al. (2014).
10. In most of the estimation results, the adverse impact associated with bank damage lasted a maximum of one year, starting either from FY1995 when we focused on damage to banks’ headquarter or from FY1996 when we focused on damage to banks’ branch network.
11. Uchida, H., I. Uesugi, A. Ono, K. Hosono, and D. Miyakawa (2014b), “The Tohoku Earthquake, Firm Activities, and Corporate Finance,” (in Japanese) mimeo.
12. Uchida, H., D. Miyakawa, K. Hosono, A. Ono, T. Uchino, and I. Uesugi (2014a), “Financial Shocks, Bankruptcy, and Natural Selection,” mimeo.