Elsevier

European Economic Review

Volume 138, September 2021, 103823
European Economic Review

Financial frictions, real estate collateral and small firm activity in Europe

https://doi.org/10.1016/j.euroecorev.2021.103823Get rights and content

Abstract

We investigate the importance of housing-based collateral for small and young – i.e. credit constrained – firms across six European economies. We find that borrowing, investment, and employment are all more strongly correlated with house price growth in these small and young firms, compared with slightly larger or older firms. This effect is on average stronger in the boom years, before the global financial crisis, and more pronounced in countries with more lengthy bankruptcy resolution procedures.

Introduction

Smaller and younger firms often face difficulties in accessing finance due to informational asymmetries (Beck et al., 2006, Gertler and Gilchrist, 1994). Typically, such firms overcome informational asymmetries by pledging collateral, which enhances their borrowing capacity (Barro, 1976, Hart and Moore, 1994, Kirschenmann, 2016, Stiglitz and Weiss, 1981). Residential real estate constitutes a common source of entrepreneurial collateral for small firms and, as a corollary, the value of real estate drives their activity (see for instance: Adelino et al., 2015 for the United States; Bahaj et al., 2020 for the United Kingdom; Schmalz et al., 2017 for France).

In this paper we examine the relationship between house prices and the activity of small and young firms using firm-level data from 6 European countries (Spain, Italy, France, Portugal, the United Kingdom, and Sweden) between 2004 and 2012. This time period includes rising as well as falling house prices but avoids the confounding influence of some regulatory changes that followed the Eurozone crisis.

Following Adelino et al. (2015)’s US study, we identify the effect of house price growth on firm activity by examining the differential effect that house price changes exert on very small firms compared to slightly larger firms. In addition to documenting the employment effect studied in Adelino et al. (2015), we examine the impact of house price developments on firm borrowing and investment; variables that are arguably more closely determined by a firm’s borrowing capacity.

We also extend our analysis to study the relationship between house prices and the activity of young firms. Young firms are more likely to be financially constrained, compared with similar sized older ones; not least because young firms have not had time to establish the banking relationships that can help firms overcome financial frictions (Petersen and Rajan, 1994, Berger and Udell, 1995, Kirschenmann, 2016).

We find that across European economies, borrowing, investment and employment are more sensitive to changes in local real estate prices in small firms compared with similar though slightly larger firms. The key result can be observed in Fig. 1, which plots average growth in firm borrowing in a region against average house price changes in the same region in a given year. The figure shows that the slope of the relationship between house price growth and borrowing is steeper for very small firms (<100,000 USD in total assets) compared to their larger peers (<1,000,000 USD in total assets). This is consistent with rising collateral values easing credit constraints of small firms. Our paper thus confirms that the findings in Adelino et al. (2015) hold across multiple European economies using a consistent methodology. Rising house prices boost small firm collateral and thus relax their borrowing constraints. This enables small firms to raise investment. For small firm employment, however, the effects are less clear.

By contrast we show that for young firms, financial constraints eased by rising collateral values through house price increases also lead these firms to increase employment (in addition to investment and borrowing). This is consistent with Davis and Haltiwanger (2019) who document that young-firm activity co-moves strongly with local house price growth in the United States by easing collateral as well as liquidity constraints. The latter potentially being more relevant for employment through the provision of working capital. The finding that small and young firms rely on real estate collateral is confirmed by the statements of businesses themselves. In particular, firms that are young or small report having to use real estate collateral to a much greater degree in the European Central Bank’s Survey of Access to Finance for Enterprises (SAFE).

Our results also point to interesting and novel heterogeneity in the strength of the correlation between firm borrowing, investment and employment across countries. In particular, we find that small firm borrowing, investment and employment are more sensitive to local real estate prices in countries with more drawn out contract enforcement and insolvency proceedings (Fig. 2). This observation is only suggestive, given our admittedly limited cross-country sample. That said, we also find a higher sensitivity of financially constrained firms’ borrowing, investment and employment to local real estate prices in Italian regions with lower court efficiency.

Finally, we compare the influence of financial constraints in periods of rising house prices relative to periods when they declined. We thereby split our sample into the period prior to the global financial crisis and the subsequent period. On average we find evidence that financial constraints bind in both periods. However, our estimates suggest that rising house prices exert a more pronounced effect. This is consistent with the notion that financial constraints are more binding on small firm activity when these firms want to expand, while falling collateral values contribute to deleveraging forces.

Our baseline methodology largely follows Adelino et al. (2015) in that we identify the influence of financial constraints by testing whether the activities of smaller or younger firms, which are a priori more likely to be financially constrained, are more responsive to real estate prices than slightly larger or older firms. In our baseline specification, we make use of data on real estate price changes for around 20 regions2 in each country and relate these changes to the activity of small firms (<100,000 USD in total assets) relative to slightly larger firms (<1,000,000 USD in total assets) in the same industry and region. In so doing, we are essentially estimating a quasi-difference in difference specification. Our effect of interest is identified by the fact that, all else equal, smaller or younger firms are likely to be more constrained. Given that we are primarily interested in the interaction coefficient of “small firm” and ”real estate price changes”, we can include region*time fixed effects, which absorb a number of possibly confounding influences. In all our analyses, we also control for a host of company specific factors, such as existing leverage, profitability, industry performance, and various size measures.

Despite being able to include detailed controls, we are left with two identification challenges. First, given that we do not have complete information about loan applications or an entrepreneur’s private collateral, we cannot rule out that changes in aggregate conditions affect both small firms and house prices simultaneously. Second, consumer demand can be influenced by house price changes as was shown clearly by Mian et al. (2013). Households which experience a house-price based wealth increase, might consume more, which in turn could benefit small local firms.

In order to address the first identification challenge, we also conduct instrumental variable regressions. Following Adelino et al. (2015) we instrument house price changes with land supply in a set of additional analyses. This paper is one of the first to make use of land supply data for this purpose in the European context. Isolating exogenous house price changes allows us to abstract from aggregate influences that might drive both prices and firm activity. We argue that, when controlling for local characteristics, land supply is independent of short-term changes in local lending- or business conditions.

Addressing the concern that our results are driven by consumer demand is empirically more difficult. Firstly, we argue that all our specifications make use of samples of relatively small firms that may be similarly affected by local demand. After all, our identification strategy exploits the additional impact of a firm being relatively more financially constrained. Secondly, we are able to examine the differences in the reaction of tradeable and non-tradeable sectors. This follows research by Mian et al. (2014). Demand for non-tradeable goods by consumers is possibly affected more directly by local economic conditions. Firms in tradeable sectors may be more easily able to sell across regional lines and be hedged against local consumer demand. While we document a small difference in the responsiveness of small firm borrowing to house price changes between the two types of sectors, as would be expected, we also show that both are nevertheless affected by local house price changes. This implies that we are likely capturing the effects of credit supply.

While we are unable to capture firm-specific real estate holdings in our paper, we follow a long and still active literature that uses regional house prices and locations of firms to understand the influence of financial conditions on small firm activity (e.g. Davis and Haltiwanger, 2019). We make use of a number of tests and alternate specifications to show that financial constraints are a likely driver for the observed differences in activity between small or young firms and those of their larger or older peers.

Our work joins a rich body of research on the collateral channel of credit supply and the importance of the value of housing for firm activity. Using US county level data, a study by Adelino et al. (2015) found that rising house prices had a positive impact on small relative to large firm employment in the same geographical region in 2002–07. They found that increases in the value of firms’ collateral boosted investment. Schmalz et al. (2017) found that housing wealth was an important factor in the decision to start a new firm, as well as a determinant of growth, investment and employment of new firms in France. Bahaj et al. (2020) estimate the differential impact of housing equity by comparing activity in firms where the directors own residential real estate relative to those that do not. Fort et al. (2013) found that the collapse of house prices accounted for a significant part of the large decline of employment growth in young and small businesses. Mehrotra and Sergeyev (2016) found that declines in US housing prices diminished job creation, with a larger impact on smaller and younger firms, consistent with the collateral channel. Pintér (2019) found that regional UK house price declines were associated with higher unemployment and estimated a model with collateral constraints to explain this result. Chaney et al. (2012) examined the relationship between collateral and investment using firm-level data for US listed corporations. Giroud and Mueller (2015), though not analyzing collateral-based credit supply, found that the regional variation in unemployment due to house price declines was almost entirely driven by the shedding of workers in firms that had an above median increase in leverage in 2002–06, i.e. firms that were more likely to be financially constrained at the start of the recession.

Our paper extends the existing literature on the lending collateral channel along two key dimensions. First and foremost, we compare the impact of the collateral channel across countries within the European Economic Area. We show that it varies strongly and suggest a link between this variation and to financial frictions and contract enforcement. In so doing, we also contribute to literature on the link between regulatory regimes and lending. Second, our empirical strategy is novel in that it specifically identifies the collateral effect for an important group; i.e. young and small firms. These have received less attention, yet account for a large share of employment in Europe and can often be significant determinants of aggregate economic growth.

The remainder of the paper is organized as follows. Section 2 presents some concepts pertaining to the importance of collateral in small and young firms across Europe. Section 3 details our data, some summary statistics, and first visual results. Section 4 outlines our baseline methodology in greater detail and shows how we avoid the confounding influence of demand effects. Section 5 explores alternate specifications of the regressions, such as the IV methodology. It also explores extensions of our methodology that test certain implications of our ideas, which should be visible in the data if our basic assumptions are valid. Section 6 discussed Robustness tests and Section 7 briefly concludes the study by also offering policy perspectives.

Section snippets

The importance of real estate collateral across Europe

It is a well-established principle that small firms make use of collateral to avoid borrowing constraints. In 2015, the ECB’s Survey on the Access to Finance of Enterprises (SAFE) asked a new question about the use of collateral by firms. In France, Spain and Italy, 62% of small firms with fewer than 50 employees report needing collateral to acquire financing. Of these, half report using personal assets, including their own house, as collateral (vs. only 5% of larger firms). The effects are

Data description and summary statistics

Our analysis is based on six European countries: Spain, Italy, France, Portugal, the United Kingdom and Sweden. Our firm-level data is from the ORBIS/AMADEUS database provided by Bureau van Dijk. The financial statement data is collected from local company registers and available at an annual frequency. We use data for the years 2004–2012.4 These years include a period of economic and house price growth, and the onset of the financial and sovereign debt

Methodology

In our baseline specification, we relate changes in local residential real estate prices to the changes in the activity of small (or young) firms, relative to slightly larger (or older) firms, operating in that area. The assumption underlying our methodology is that, on average, entrepreneurs/small firm owners will live close to where they open their business. Especially for small firms, this assumption seems justifiable. We run this analysis for 6 different countries (Spain, Italy, France, the

Results

Our central hypothesis is that the availability of collateral through increased house prices is more valuable for more financially constrained firms. This effect should be visible through a stronger influence of rising house prices on, first, the borrowing of financially constrained firms and, ultimately, on investment and employment as these firms use the increased financial resources to expand activity. We first proxy financial constraints by firm size following Adelino et al. (2015) but also

Robustness tests

Despite being able to include detailed firm and regional controls, we are left with two identification challenges. Given that we do not have full information about loan applications or an entrepreneur’s private collateral, we cannot rule out that changes in aggregate conditions affect both small firms and house prices simultaneously. Similarly, consumer demand can be influenced by house price changes as shown clearly by Mian et al. (2013). Households which experience a house-price based wealth

Conclusion

We present evidence that rising house prices boost small firm collateral and thus relax firms’ borrowing constraints. We show that this holds across a number of European economies using a consistent methodology.11 We further find that this additional borrowing enables small firms to raise investment though not necessarily employment. By contrast, we show that for young firms, rising real estate collateral values help these

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    We thank the editors, Peter Rupert and Luca Benati and two anonymous referees. We also thank Viral Acharya, Yakov Amihud, Marc Arnold, Bo Becker, Martin Brown, Markus Brunnermeier, Geraldo Cerqueiro, Leonardo Gambacorta, Emilia Garcia-Appendini, Xavier Giroud, Galina Hale, Vasso Ioannidou, Tor Jacobson, Sebnem Kalemli-Ozcan, Cathérine Koch, Gianni LaCava, Dubravko Mihaljek, Holger Mueller, Steven Ongena, Markus Schmid, Thomas Spycher, Serafeim Tsoukas, Michelle Zemel, an anonymous referee for the BIS-WP series as well as conference/seminar participants at the Bank for International Settlements, European Investment Bank, the Financial Research Workshop Calcutta, IBEFA at Western Economic Association, the Royal Economic Society, and the University of St. Gallen for helpful comments and suggestions. We would also like to thank Francesco Zolli for the updated Italian regional house price data.

    The opinions expressed in this paper do not necessarily reflect those of the Bank for International Settlements and the Federal Reserve Bank of New York or any members of the Federal Reserve System. Any errors are our own.

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