Leverage Limits in Good and Bad Times" with Cynthia Balloch
Abstract:
How do leverage limits affect lending? We examine a regulatory change to the business development company (BDC) lending sector, which allowed lenders to double their regulatory leverage constraint. Exploiting the staggered timing of approvals, we show that this allowed firms to slowly adjust loan portfolios and increase leverage, but suddenly increase the unrealized losses reported on their loans. These patterns around approvals suggest that the slackness of regulatory constraints has important effects on lenders' incentives to accurately assess fair value. In addition, we explore how the pandemic differentially affected BDCs that were close to or far from their leverage limits. Our results shed light on an important lending sector for small businesses, which has grown dramatically since the Great Recession.