The hypotheses in short

All effects are stated as isolated arguments. Some of the effects are oppositely directed, some one way directed, and it is an assessment of their combined impact that is summarized in 7 hypotheses.

Hypothesis I. Effect 1, 2 and 3 argue for and against banks’ enhanced capital access.

Summarizing effect 1 and 2, I would argue that depositors’ lack of confidence in banks is larger than their lack of confidence in the secondary market, thus the combined effect is in favour of bank-loans. Effect 3 on interbank lending on the other hand is expected to have significant impact on total liquidity and liquidity risk. In order to enhance liquidity and thus reduce the liquidity risk, all types of assets are expected to be reduced. This will mostly affect bank loans, unless security holders others than banks reduce their holding of securities with the same degree as banks do. Bank loans are the least liquid type of financial assets, so they are reduced more slowly than securities. The total effect of reduced interbank lending is expected to countervail higher consumer deposits. The reduction in the NFC’s securities are at first more severe, but reduction in bank loans will continue over a longer time.

37 Hypothesis II. Effect 4 states that government bonds are expected to serve as an appealing alternative to deposit savings thus lowering the risk free interest rate premium, the effective bond rate and equity returns. The impact on equity is expected to be limited, as the interest rate premium accounts for a small fraction of the total cost of capital. Effect 12 adds the effect of expansionary monetary policy. This results in a higher demand of bonds which lowers the interest rate premium even more. The total effect is expected to be significant simply because the agenda of central banks was to stimulate investments and consumption. However, the effect is expected to be greatest for bond levels, then bank loans levels and the least affected capital source is expected to be equity. The effect is not expected until the central banks assess that the risk of real economic slowdown is present.

Hypothesis III. Effect 5 concerns the impact of banks on the financial market through defaults in Asset Backed Securities. The overall level of NFC external finance will decrease:

Partly because the credit risk premium increases and partly because banks sell securities, redeem loans and reduce new investments and lending to increase their cash holdings. For the remaining securities and bank loans, held by banks, high risk liquid assets are preferred. The risk premium for NFC securities has increased while they are more liquid than bank loans.

This makes securities more appealing for banks. Thus, banks are expected to increase their holdings of securities at the expense of bank loans. The NFC equity and bond prices are expected to rebound, while bank loans are expected to decrease steadily. The change in security financing of NFCs, also depends on the behaviour of other security holders and their share of the securities market.

Hypothesis IV. Effect 7 states that a basic higher level of systematic risk occurs in market-based countries, because a higher degree of liberalization increases credit aggregates and thus enhances interdependence. This results in a larger rational change in risk perception for market-based countries. Evidence shows that investors assess expected returns and risks using few recent observations. Consequently, they put too little weight on the danger of low returns, as good times had lasted long when the crisis occurred. Since returns before the crisis were expected to be higher in high risk (market-based) countries, so was the miscalculation of downside risk. The effect was a larger increase in required risk premium for all financial assets. Furthermore Effect 8 emphasises that especially the required risk premium (and thus value reduction) associated to equity would increase. The required risk premium would increase less for bonds and least for bank loans. As long as the change is rational it should not

38 change NFC’s preferred mix of new external finance. However, it can impact the amount of profitable investments thus resulting in lower net-transactions for all types of finance.

Hypothesis V. Effect 10 argues that panics stemming from changes in perceived credit risk enhance the liquidity risk of the financial markets. This enhances the liquidity premium and decreases the price even further than what the change in credit risk did. The effect is expected to be largest for:

a. Financial assets subject to high systematic risk; that is assets in market-based countries and especially equity and then bonds. The probability of panics is expected to increase as a function of systematic risk, because high systematic risk results in a larger percentage loss of the portfolio and this hurts more. Investors sell to avoid further loses.

b. Liquid markets where signalling plays a larger role. Reliance on signalling can reinforce irrational volatility and thereby increase liquidity risk. If the market, for some reason, loses its confidence in the price it will drop heavily because; (i) many investors must agree for a price to drop heavily and thus there must be a good reason for it. (ii) If investors realize that irrational price drops are a consequence of the first price drop, the price will drop even further. As liquidity is expected to be larger in market-based economies so is the effect.

Hypothesis VI. Effect 6 argues against Effect 5 while introducing the role of irrational behaviour. One thing is that banks might increase their preferred risk level. Another thing is if the market volatility is based on irrational reactions. Under such circumstances profit can be better earned by using direct screening and monitoring, that is by granting loans opposed to investing in securities. Effect 11 suggests that NFCs for the exact same reason prefer loans since the price of these allows for a more rational risk assessment and thus more profitable projects. The risk of NFCs conducting moral hazard is less severe because the interdependence between the bank and the NFC is greater. This and a larger interest in keeping the NFCs running motivate banks to grant loans. The effect is expected to be largest in market-based countries where panics are expected to be more severe.

Hypothesis VII. Effect 13 suggests that at a certain risk level, NFCs estimate fewer projects to have a positive NPV, because the prospect of income in the following years are lower than before the crisis. This will reduce net-transactions for all types of finance and the market price of equity.

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