Board of Governors of the Federal Reserve System

September 2011

Allocation and Financial Market Frictions: Some Direct Evidence from the Dispersion in Borrowing Costs

Simon Gilchrist, Jae W. Sim, and Egon Zakrajsek

Abstract:

Financial market frictions distort the allocation of resources among productive units--all else equal, firms whose financing choices are affected by financial frictions face higher borrowing costs than firms with ready access to capital markets. As a result, input choices may differ systematically across firms in ways that are unrelated to their productive efficiency. We propose a simple accounting framework that allows us to assess the empirical magnitude of the loss in aggregate resources due to such misallocation. To a second-order approximation, our accounting framework requires only information on the dispersion in borrowing costs across firms. We measure firm-specific borrowing costs for a subset of U.S. manufacturing firms directly from the interest rate spreads on their outstanding publicly-traded debt. Given the observed variation in borrowing costs, our approximation method implies a relatively modest loss in efficiency due to resource misallocation--on the order of 1 to 2 percent of measured total factor productivity (TFP). According to our accounting framework, the correlation between firm size and borrowing costs is irrelevant under the assumption that financial distortions and firm-level efficiency are jointly log-normally distributed. To take into account the effect of covariation between firm size and borrowing costs, we also consider a more general framework that dispenses with the assumption of log-normality and which yields somewhat higher estimates of the resource losses--about 3.5 percent of measured TFP. Counterfactual experiments indicate that dispersion in borrowing costs must be an order of magnitude higher than that observed in the U.S. financial data, in order for misallocation--arising from financial distortion--to account for a significant fraction of measured TFP differentials across countries.

Keywords: Misallocation, financial market frictions, borrowing costs, firm-level evidence

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