Commercial Paper Corporate Finance And The Business Cycle A Microeconomic Perspective

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NBER Working Paper No. 4848, Commercial Paper, Corporate Finance, and the Business Cycle: A Microeconomic Perspective, by Charles W. Calomiris, Charles P. Himmelberg and Paul Wachtel, dated September 1994 and prepared for the April 1994 Carnegie-Rochester Conference on Public Policy. The paper builds a panel dataset linking Moody's commercial paper data with Standard and Poor's Compustat for slightly more than 3300 domestic manufacturing firms. It states that access to the commercial paper market depends on large size, high earnings and large stocks of liquid assets, and that firm-level commercial paper is procyclical although aggregate issuance is countercyclical. It offers three explanations: shifts in portfolio demand, financing of accounts receivable, and inventory financing. The document opens with a history of the commercial paper market and closes with a reference list.

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NBER WORKING PAPER SERIES

COMMERCIAL PAPER,
CORPORATE FINANCE, AND
THE BUSINESS CYCLE:

A MICROECONOMIC PERSPECTIVE

Charles W. Calomiris
Charles P. Himmelberg
Paul Wachtel

Working Paper No. 4848

NATIONAL BUREAU OF ECONOMIC RESEARCH
1050 Massachusetts Avenue
Cambridge, MA 02138
September 1994

This paper was prepared for the April 1994 Carnegie-Rochester Conference on Public Policy.
The authors thank Douglas Diamond, Mark Gertler, Simon Gilchrist, Anil Kashyap, Randy
Kroszner, Ken Kuttner, Bruce Petersen, participants at the Carnegie-Rochester Conference, and
seminar participants at the City University of New York, the University of Chicago, the Federal
Reserve Bank of Chicago, and the NBER Summer Institute for helpful comments. We thank
Jerry Fons for making the Moody’s commercial paper data available, Peter Rousseau for his help
in preparing the data set, and Burt Porter and Arjun Jayaraman for their assistance. This paper
is part of NBER’s research programs in the Development of the American Economy and
Monetary Economics. Any opinions expressed are those of the authors and not those of the
National Bureau of Economic Research.

© 1994 by Charles W. Calomiris, Charles P. Himmelberg, and Paul Wachtel. All rights reserved.
Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission
provided that full credit, including © notice, is given to the source.

NBER Working Paper #4848
September 1994

COMMERCIAL PAPER,
CORPORATE FINANCE, AND
THE BUSINESS CYCLE:

A MICROECONOMIC PERSPECTIVE

ABSTRACT

Little is known about the characteristics or behavior of individual commercial paper
issuers, or about the reasons for the countercyclical issuance of commercial paper in the
aggregate. To address these issues we construct a new panel dataset linking Moody’s data on
commercial paper issues with Standard and Poor’s Compustat.

High credit quality is a requirement for entry into the commercial paper market, but long-
term credit quality (bond rating) is not a sufficient statistic for short-term quality. Holding
constant long-term credit quality, access to the commercial paper market depends on large size,
low earings variance, high carnings, and large stocks of liquid assets. These characteristics
allow firms to issue near-riskless short-term debt and supply a near-money asset to the market,
thereby reducing their interest costs by the amount of the commercial paper liquidity premium.

We find that low-credit-quality firms have higher stocks of inventories and financial
assets. Low-quality firms also display greater cash flow sensitivity of inventories and financial
assets. This suggests that, in contrast to commercial paper issuers, lower quality firms face
financing constraints that lead them to accumulate “buffer stocks" of liquid assets.

In contrast to the countercyclicality of aggregate commercial paper, we find that firm-level
commercial paper is procyclical. Our data support three explanations for this apparent
contradiction, all of which recognize that commercial paper issuers are atypical. First, firms of
high credit quality can use commercial paper to finance inventory accumulation during
downturns. Second, they also can use commercial paper to finance countercyclical increases in
accounts receivable. This suggests that commercial paper issuers serve as intermediaries for other
firms during downturns. Third, it may be that portfolio demand for commercial paper -- a highly
liquid, safe asset -- increases ‘during downturns.

Charles W. Calomiris Charles P. Himmelberg Paul Wachtel
Department of Finance Stern School of Business Stern School of Business
University of Illinois New York University New York University
Champaign, IL 61820 44 West 4th Street 44 West 4th Street

and NBER New York, NY 10012 New York, NY 10012

INTRODUCTION

Commercial paper accounts for a large and growing fraction of short-term corporate
finance in the United States. Despite its growing importance for corporate finance and despite
the attention paid by macroeconomists to commercial paper as a leading economic indicator
(Stock and Watson, 1989; Bernanke, 1990; Friedman and Kuttner, 1993 a and b; Kashyap, Stein
and Wilcox, 1993), there has been virtually no econometric analysis of the characteristics of
commercial paper issuers or the circumstances under which commercial paper issuance rises or
falis. This is a surprising omission, given that commercial paper is the only form of publicly
traded short-term debt placed by corporations.

Interest in the role of commercial paper increased during the “credit crunch" of 1989-92
(see Federal Reserve Bank of New York, 1994). At that time, bank lending fell, largely because
of the weakened condition of banks, while commercial paper issuance increased. Many
observers suggested that the commercial paper market was providing a substitute for bank
lending. The tale of the firm that was squeezed out of the bank loan market and tumed to the
commercial paper market was often told (see Gertler’s discussion following Friedman and
Kuttner [1993a]). It was an appealing story because it fit the macroeconomic facts -- a decline
in bank loans and an increase in commercial paper outstanding.’ However, by looking for the
first time at the characteristics of commercial paper issuers, we show that this simple substitution
story does not fit the microeconomic facts. That is, there is no indication of commercial paper
issuance in a downturn by firms that might have been squeezed out of bank lending.

We show that commercial paper issuance is restricted to firms with the strong balance

sheets and high cash flows. This alone suggests that it is wrong to hypothesize that increased

of bank lending. Moreover, the balance sheets of commercial paper issuers do not appear to
change much in quality over the course of a business cycle. This fact provides additional
evidence against the "squeeze" hypothesis for the representative firm. Thus, there must be other
reasons why some firms increase commercial paper issuance during downturns.

We argue that the evidence is more consistent with three other hypotheses: (i) that there
may be counter-cyclical shifts in the aggregate demand for monetary assets (namely commercial
paper supplied by the high quality firms); (ii) that commercial paper may be issued by high
quality firms to finance the extension of trade credit to lesser-quality firms, i.e., inter-firm
financial intermediation may be counter-cyclical; (iii) that increased commercial paper issuance
may occur to finance the accumulation of inventories by the issuer around a business cycle peak.

The first hypothesis is that the portfolio demand for monetary assets is countercyclical,
i.e. there is a flight to quality during a downtum. Firms with strong balance sheets exploit this
demand to reduce their cost of short-term borrowing. We find this plausible, and while our data
are unsuited for directly testing for such demand shifts, the results below are consistent with this
view.

Our second explanation is that firms in strong financial condition issue commercial paper
during downturns in order to extend credit to other firms; commercial Paper issuers act as
financial intermediaries to other firms.? While we once again face data limitations, we do find
that commercial paper is strongly correlated with increases in accounts receivable, suggesting
the possibility of a causal link.? Such a link would favor a more nuanced view of the "squeeze"
hypothesis that dispenses with the representative firm: reductions in the supply of bank credit

increase the demand for inter-firm financing, thus leading indirectly to an increase in aggregate

commercial paper via those firms in the economy with the strongest balance sheets.

The third explanation is that increased commercial paper issuance is used to finance
inventories. Since business cycle peaks are often characterized by unplanned inventory
accumulation, the inventory cycle may help explain the countercyclical behavior of commercial
paper.

In this paper we present a wide ranging examination of issues concerning commercial
paper issuance, and provide new evidence on the characteristics and behavior of issuers
compared to non-issuers. Our chief goals are to use a panel of firm-level data to identify the
characteristics of firms that have access to the paper market, and to describe the determinants
of changes in an individual firm’s paper outstanding. We address a number of previously
unanswered questions. For example:

* How do the characteristics of short-term public debt issuers differ from those of long-

term public debt issuers and issuers of private debt?

* Are there special circumstances that lead firms to increase short-term public debt?

* Are changes in commercial paper issuance driven by the same factors that affect other

forms of financing?

Our data set is based on quarterly data on commercial paper outstanding and ratings for
issuers rated by Moody's for the period 1985II through 19921. These data are merged with
financial data from Standard and Poor’s Compustat. There are slightly more than 3300
domestic, non-subsidiary manufacturing firms in our universe, and about ten percent of them
have commercial paper programs. These unique panel data allow us to relate the micro behavior

of firms to the macro facts about commercial paper.

Commercial paper finance is not well explained by most models of short-term debt.
Most models of short-term debt emphasize its advantages (over long-term debt) when the issuin 4
firm has information that debt holders do not have. Short-term financing emerges so that lenders
can impose discipline on the borrowing firm. Such models tend to neglect the portfolio
attributes of debt instruments. This is important because an outstanding feature of commercial
paper -- a feature that usefully distinguishes it from bank debt -- is that it provides money-like
services. Since commercial paper is a money market instrument (a near-money asset), a
liquidity premium’ accrues to issuers in the form of lower interest costs. In order to reduce
short-term borrowing costs, all firms would like to issue such liabilities. But only the highest-
quality firms qualify for the commercial paper market because purchasers of near-money assets
demand little or no risk of default.

Our empirical findings show that conditional on aggregate demand shifts, exit from the
commercial paper market is strongly associated with reductions in balance sheet strength.
Furthermore, the characteristics of issuers vs. non-issuers indicate that high credit quality (a
strong balance, sheet and high cash flow) is the sine qua non for issuers. Moreover,
improvements in the financial condition of the firm are associated with increases in commercial
paper outstanding. Finally, we find that firms with high credit quality maintain much lower
levels of working capital. In contrast to commercial paper issuers, non-issuers display much
higher sensitivity of inventory and working capital investment to fluctuations in cash flow,
suggesting that the shadow cost of funds for non-issvers is high.’ That is, not only does high
credit quality reduce the costs of short-term funds obtained through lower interest rates on

commercial paper, it also appears to reduce the unobserved costs of short-term funds.

In addition to the above, we provide evidence that links our work to previous studies that
have used access to long-term debt (bond markets) as an indicator of access to capital markets.

We show that long-term creditworthiness, as measured by bond ratings, does not fully capture

‘short-term creditworthiness, as measured by access to the commercial paper market. Despite

the close association between long-term and short-term credit quality, there are interesting
differences between the determinants of high bond ratings and the determinants of access to the
commercial paper market.

The evidence in this paper supports a new interpretation of the countercyclical movement
of aggregate commercial paper issuance. While commercial paper issuance is countercyclica]
at the aggregate level, it is procyclical at the firm level (positively correlated with sales and
earnings). The macroeconomic fact that commercial paper issuance rises in recessions (during
which balance sheets usually weaken) seems to contradict our microeconomic evidence that
commercial paper is always associated with high credit quality. Obviously it is essential to
recognize firm heterogeneity in order to resolve the paradox. We build on this basic insight to
argue that commercial paper issuance moves countercyclically due to shocks originating outside
of issuing firms. As suggested at the outset, three likely sources of such shocks are shifts in the
portfolio demand for monetary assets, shifts in the demand for firm-intermediated credit, and
shifts in the need to finance inventories. All of these would explain the countercyclical
expansion of aggregate commercial paper and all are consistent with the evidence on firm-level
behavior that we present below. The next section of the paper provides a brief historical
overview of the development of the commercial paper market and its growth during the postwar

period. It is followed by a discussion of theoretical perspectives from the corporate finance

literature on the potential advantages of short-term debt. The empirical results are reported in
the next three sections. First, we provide a firm-level analysis of the characteristics of firms
that issue commercial paper, and consider factors that are associated with increases and
decreases in commercial paper outstanding (including exit). Second, we examine the behavioral
differences between issuers and non-issuers by considering the response of inventory and
financial working capital investment to cash-flow disturbances. Finally, we report evidence on
the procyclicality of commercial paper at the firm level. We conclude with a summary and our

interpretation of the facts.

DEVEL! ROWTH THE COMMERCIAL PAPER M.

Hi mmerci

Commercial paper, broadly defined as unsecured, short-term negotiable promissory notes
sold on the open market, is a financial instrament with a long history in the United States.
There are three distinct stages in the history of the American commercial paper markets
following its emergence during the postbellum period. In the first stage, commercial paper grew
rapidly as a source of corporate financing from the late nineteenth century until the 1920s and
then all but disappeared during the Depression (see James 1978, 1993; Selden, 1963). The
second stage began after the War and is characterized by very rapid growth in commercial paper
outstanding in the 1960s. This stage ended with the Penn-Central failure which severely shook
the market and temporarily halted its growth (see Schadrack and Breimyer, 1970; Calomiris,
1994). The third stage began after the Penn-Central failure and continues to the present (see

Rowe, 1986; Hahn, 1993; Post, 1992).

Although the institutional characteristics of the commercial paper market and the
characteristics of issuers and buyers have changed over the last century, there is one aspect of
the history of the instrument that reappears in each stage of its growth. The defining issue for
understanding the growth of commercial paper is the relationship between the paper market and
commercial bank portfolios. At various times the growth of the commercial paper market could
be attributed to (i) banks with weak loan demand that were searching for an alternative asset,
(ii) regulatory constraints that made bank deposits unattractive or (iii) market conditions that
made bank loans relatively expensive.

According to James (1978, 1993) and Calomiris (1992), the rapid growth of commercial]
paper in the late 19th century was due to limitations on bank lending resulting from restrictions
on branch banking. In the early part of the century, commercial paper was a well established
supplementary borrowing source for the best rated companies. Commercial banks were the
principal holders of commercial paper in this era. Commercial paper played an important role
in a highly segmented banking market. Banks with relatively low local credit demand could
participate in the national loan market by holding commercial paper. The United States was
unique in this respect. In other countries, banking systems operated nationwide branching
networks and relied on bankers acceptances as the main form of commercial finance. Direct
long-distance lending for commercial purposes through bankers acceptances within the United
States was hampered by the unit banking system, which limited the potential for interregional
flows of interbank credit. Commercial paper provided as alternative means for the most
creditworthy borrowers in peripheral regions to raise funds at peak lending times from money-

center banks directly.*

The market all but disappeared by the end of the 1920s, even before the onset of the
Depression. James (1993) traces the decline of commercial paper to the bank consolidation
wave of the 1920s. Large city banks with growing deposit bases were better able to
accommodate growing inter-regional flows of credit in the 1920s which made bank loans
(including bankers acceptances) a cheaper source of credit than commercial paper. Another
contributing factor was the Federal Reserve’s policy of favoring bankers acceptances as collateral
for discount lending, which was a conscious effort to increase the relative importance of
acceptances, and reduce the importance of commercial paper (Hackley, 1973, 55-58).

In the postwar period, commercial paper and bank loans became competing sources of
corporate financing rather than complementary bank assets.’ The postwar reemergence of the
commercial paper market was driven by the growth of finance companies and the demand for
a liquid and safe asset. Until the advent of large negotiable CDs in 1961, there were few other
liquid assets with attractive rates. Nevertheless, the commercial paper market did not explode
until later, when regulatory restrictions gave it a tremendous boost.

In the late 1960s - starting with the credit crunch period of late 1966 - open market rates
exceeded the Regulation Q ceilings that banks could pay on CDs. As a result, banks could not
raise money to satisfy the robust loan demand during the Viet-Nam War expansion. Banks
funded loans in part by raising funds through their subsidiaries in the paper market and non-
financial firms went directly to the commercial paper market. Schadrack and Breimyer (1970)
maintained that the Regulation Q ceilings created a classical credit crunch. Restrictions on
deposit interest rates reduced the supply of bank loans, and encouraged the growth of the

commercial paper market.

The rapid growth in commercial paper temporarily crashed to a halt with the Penn
Central failure in June 1970. Calomiris (1994) argues that the surprising failure of Penn Central
produced a reexamination of the pricing of risk in the commercial paper market, and led to the
introduction of formal rating of commercial paper programs. The crisis also ushered in a new
institutional feature: "backup lines" for commercial paper programs, issued by banks and
required by rating agencies. Generally, these backup lines do not provide an absolute bank
guarantee of repayment to commercial paper holders. Nevertheless, the existence of the backup
lines are a “liquidity enhancement" which makes it easier for firms to obtain alternative
financing the event that firms have difficulty rolling over their paper (Calomiris, 1989).

The slowdown in the growth of commercial paper in the early 1970s reflected the
influence of voluntary restraints on administered interest rates, such as the prime rate (Hurley,
1977). The volume of outstanding paper shrank and the commercial paper rate rose substantially
above the prime rate in 1973. The commercial paper market bounced back in the mid-1970s and
began the third phase of growth. The rapid expansion began when (i) commercial paper became
a cheap source of funds after the Carter era controls on interest rates were dropped and (ii)
commercial paper became increasingly attractive to investors as the Regulation Q ceilings
became binding once again. The institutional reforms introduced in the wake of the Penn
Central crisis set the stage for orderly growth without any recurrence of a "nun" on paper like
that produced by the Penn Central crisis. Finally and most importantly, the growth of money
market mutual funds increased the demand for commercial paper dramatically. The money
market funds also influenced the development of the market because they often restrict their

portfolios to top rated paper with ratings from both major ratings agencies.

Commercial paper outstanding continued to grow rapidly in the 1980s (Post, 1992). This
growth occurred despite the fact that regulation no longer afforded any advantage to commercial
paper -- both Regulation Q and reserve requirements on CDs disappeared. Nevertheless,
commercial paper financing remained attractive because many industrial borrowers were more
credit worthy than the banks themselves, which made it difficult for banks to compete for their
business. Moreover, there was a general preference for short term financing in an era of high
interest rates. Finally, commercial paper participated in the general runup in debt during the
1980s.

Recently, the slow start of the current expansion, a general increase in the riskiness of
corporate borrowers, and a tightening by the SEC of the rules governing money market fund
holdings of commercial paper combined to shrink the commercial paper market in 1991-92
(Post, 1992). It is also possible that -- in keeping with its general tendency to grow
countercyclically -- the decline of 1991-1992 reflected, in part, a normal cyclical response (see
the discussion below).

The holders of commercial paper have changed over the years pmmarily because of the
advent of money market mutual funds. Post (1992) reports that at the end of 1991 the holders

with more than a five percent share of all commercial paper were:

Money market mutual funds 33.9%
Households, trusts and non-profits 29.3
All retirement plans 10.2
Nonfinancial corporate business 9.4

Commercial paper is a highly liquid, low risk short-term asset. Most commercial paper
is top rated by one or more of the four credit rating agencies (Moody's and Standard and Poor’s

are the most prominent; Duff and Phelps and Fitch rate only a few hundred CP programs) and,

10

as noted earlier, virtually all paper is backed by bank credit lines (see Hahn, 1993)." In many
cases where the paper issuer may be as creditworthy as any bank, the paper Is still backed by
a bank line of credit, although it is often only a partial backing. Often the holders of CP
demand this extra insurance and since 1991 SEC regulations have restricted the holdings of

below top rated CP by money market mutual funds.

Commercial paper and corporate finance

Secular growth in commercial paper has made it an important source of corporate finance
although it does not threaten the place of more traditional forms of finance. Chart 1 shows that
the ratio of non-financial commercial paper to GDP has grown from 0.5 percent of GDP in 1969
to about 2.5 percent.? By comparison, commercial bank C&I loans are about 10 percent of
GDP and nonfinancial commercial paper has increased from 10.6 percent of C&I loans in 1979
to 21.2 percent in 1991.

Most commercial paper is issued by financial companies. Non-financial issuers accounted
for 25 percent of all commercial paper in 1991 and this proportion has not changed dramatically
in the last 20 years. Nevertheless, commercial paper has become an increasingly important
source of funds for nonfinancial firms. The emphasis on the growth of non-financial commercial
paper in recent years tends to make observers forget that although the market is quite large,
commercial paper is just one of many sources of financing for the nonfinancial sector. At the
end of 1991, the credit market debt of the nonfinancial nonfarm corporate sector ($2.3 billion

in total) was distributed among the following instruments:

11

Bonds and mortgages 60.8%

Bank loans 23.3
Commercial paper 4.3
Other loans 11.5

Commercial paper was 6.1 percent of al] short-term liabilities (non-mortgage loans, short-term
paper, taxes payable, and trade debt). Thus, other balance sheet items can be used, even in the
short-run, to accommodate financing needs. For example, net trade credit of the sector is almost
twice as large as commercial paper borrowing.

It is also important to point out that only a small number of non-financial firms issue
commercial paper. At the end of 1989, Moodys rated 1861 commercial paper programs
(including financial and non-financial corporations). This figure is about three times as large
as the number of programs a decade earlier (see Moody's, 1989). The vast majority of the
programs (86%) have a top rating (Prime-1).

Because commercial paper has a short-term maturity, it is usually viewed as a short-term
liability of the issuer but this does not mean that issuers use paper only to finance short-term
needs. Financial firms roll over their paper continuously. Similarly, nonfinancial firms often
use commercial paper as financing for capital expenditures and roll it over continuously or until
alternative financing is found. Thus, it is often correct to view commercial paper as long-term
financing with variable terms tied to short-term rates. FASB accounting rules allow firms that
use commercial paper to finance capital expenditures to carry the commercial paper on their

balance sheets as long-term debt (Stigum, 1983, p. 634).

12

The unusual counter-cyclical behavior of commercial paper outstanding was first observed
by Selden (1963) who showed that in each of three recessions -- 1953-54, 1957-58 and 1960-61 -
- the growth in commercial paper outstanding accelerated in the recession, then declined in the
early part of the expansion and grew moderately for the remainder of the expansion. The
cyclical behavior of commercial paper outstanding in the last five recessions is quite similar.
Chart 2 shows the behavior of non-financial commercial paper outstanding around the five
business cycle peaks from December 1969 to July 1990, with each series normalized at the value
in the peak month. In each instance, the value outstanding increased in the recession and, with
the exception of the last recession, outstanding paper rose by more than 20 percent within 6
months of the peak.

Recent research on commercial paper (notably Kashyap, Stein, and Wilcox, 1993) has
emphasized the cyclical behavior of the capital structures of firms. Specifically, commercial
paper and bank loans tend to move in opposite directions over the business cycle. Charts 3 and
4 show the ratios of bank loans and commercial paper, respectively, to the total credit market
debt of the non-farm non-financial corporate business sector from the Flow of Funds. There is
some indication that the fall in bank lending in the late 1970s was offset by commercial paper,
but the same observation cannot be made for the Jarge decline in bank lending since the mid-
1980s.

Of course, simple flow of funds accounting is not ideal for testing this proposition, since
shocks to bank loan supply may affect the general state of the economy, which then affect the

movements in loans and commercial paper for other reasons. VAR analysis of impulse

13

responses offers more support for the proposition that tight monetary policy leads to a rise in
commercial paper (Friedman and Kuttner, 1993a). More generally, they find that any impulse
that produces a decline in economic activity tends to be associated with an increase in

outstanding non-financial commercial paper.

THEORETICAL PERSPECTIVES

The last decade has witnessed important changes in corporate finance theory and in the
way macroeconomists conceive of the links between credit markets and economic activity. Prior
to the 1980s, macroeconomic models (for example, the textbook IS-LM model) were built
around a single market for credit, and featured an equilibrium interest rate interest rate equal
to the marginal product of capital. Corporate finance theory was based on the Miller-Modigliani
equivalence between bond and equity financing, and implied that corporate financing choices
were largely governed by the tradeoff between the costs of bankruptcy (which favor equity), and
the rules for taxing corporate income (which favor debt).

These modem approaches to corporate finance were dramatic departures from long-
standing traditions that emphasized differences in access to particular credit markets (prominent
examples include Butters and Lintner (1945), Meyer and Kuh (1957), Gurley and Shaw (1960),
and Minsky (1975)). Since the mid-1970s, new developments in the economics of information
_ have paved the way for a renewed emphasis on the importance of credit market constraints on
investment and consumption (e.g., Leland and Pyle, 1977; Jaffee and Russell, 1978; Stiglitz and
Weiss, 1981). We selectively review this literature and identify models that help us to

understand the use of non-intermediated, short-term debt -- that is, commercial paper -- by non-

14

financial firms.

There is a large literature that seeks to understand the role of intermediated debt
(Diamond, 1984, 1991b; Rajan, 1992). The common theme emphasized by these researchers
is that intermediaries specialize in information production, and banks further specialize in
monitoring firms and enforcing contracts. This costly technology will be chosen by relatively —
unseasoned firms, for whom the benefit of paying for these services exceeds the costs (Fama,
1985). Other firms, namely those that can cheaply and credibly communicate information
without the assistance of intermediaries, can save these costs by placing their debt directly. This
explains the existence of long-term bonds and commercial paper.

A large and growing set of empirical findings supports this view of intermediaries (banks
in particular) as specialists in information and contro] who mainly serve unseasoned firms and
charge significant premia for their services (James and Wier, 1989; Mackie-Mason, 1990;
Booth, 1992; Slovin et al., 1993; Billett, Flannery and Garfinkel, 1993; Petersen and Rajan,
1994). The adverse macroeconomic consequences of the absence of an effective banking system
have also been analyzed in the empirical literature on economic fluctuations (Bernanke, 1983;
Calomiris, Hubbard, and Stock, 1986) and on long run growth (King and Levine, 1994; Wachtel
and Rousseau, 1994).

The second important characteristic of commercial paper is its short term maturity.
Short-term debt is usually understood in terms of its incentive advantages over long-term debt
(Harris and Raviv, 1990; Calomiris and Kahn, 1991, Calomiris, Kahn, and Krasa, 1992; Gertler
and Hubbard, 1993). Short-term contracting limits the tendency of borrowers to increase asset

risk after taking on debt. Required debt rollover implies a penalty to such a strategy that long-

15

term contracting would not imply. This is especially true for outside debt contracts (bonds),
because of the problems bondholders face in enforcing risk-limiting covenants (a large number
of holders leads to costly coordination and free-rider problems).

Two alternatives to the incentive view of short term debt that are relevant to
understanding commercial paper are Diamond (1991a) and Gorton and Pennacchi (1990).
Diamond (1991a) provides a model that explicitly addresses firms’ choices among publicly
traded long-term debt, commercial paper, and short-term bank debt. For reasons similar to
those described above, he too argues that unseasoned credit risks will be forced to rely on
intermediated, short-term debt. For firms that do not need to rely on intermediation, he uses
an adverse selection model to argue that non-intermediated, short-term debt (commercial paper)
will be chosen by high quality firms.

In Diamond’s (1991a) model, the maturity structure of the firm’s public debt recognizes
the potential costs of financial distress from short-term debt -- the possibility that the market will
downgrade a firm when it comes to the market to roll over its debt (what he calls "liquidity
risk") -- and the potential benefits of being able to renegotiate debt when favorable inside
information is revealed. Firms that know their ratings will improve will prefer short-term debt
because the benefits outweigh the costs. Under these circumstances choosing short-term debt
provides a signal of high firm quality. This model is capable of explaining why high-quality
_ firms that expect their ratings to improve because of future revelation of private information will
choose to issue commercial paper to finance long-term projects.

Despite some attractive features of this model, it does not provide a fully general

explanation for the use of commercial paper. The model explains why some firms enter the

16

commercial paper market briefly, but it does not explain the protracted use of the market by the
very highest rated firms. Given that many commercial paper issuers maintain AA or AAA
credit ratings continuously for long periods of time, it is hard to imagine that they are entering
the market in anticipation of an upcoming increase in their creditworthiness.

Moreover, adverse selection models do not seem plausible when applied to enormous,
publicly traded firms, like those that issue commercial paper. For example, utilities are highly
regulated enterprises subject to Little fundamental uncertainty or inside information, but they are
regular issuers of commercial paper.

Finally, given the small potential gains from upgrades for many firms, the transaction
costs of placing short-term debt are likely to outweigh possible benefits from earnings upgrades.
Dealers’ commissions on commercial paper average roughly 1/8 of one percent (Stigum, 1983,
p. 639), and backup lines from banks can cost as much as 1/4 of one percent (Stigum, 1983, p.
634). In contrast, the imputed annual cost of the underwriting spread for placing highly rated
long-term debt is essentially zero.'®

Gorton and Pennacchi (1990) provide an interesting alternative perspective on financial
intermediation which is useful for understanding the existence of commercial paper. Their view
is that intermediaries create liquid assets -- assets that "can serve as the basis of a safe security
that may be used by uninformed agents for transactions purposes." (p.51). However, Gorton
and Pennacchi argue that bank intermediation is not the only means of creating liquid assets.
There are some firms with asset characteristics that are sufficiently similar to financial
intermediaries that they can also directly issue liquid securities.

Limits to entry in the production of liquid securities and the extent of demand for such

17

securities imply that only the highest quality credit risks issue money market instruments like
commercial paper.'' These money market instruments will have a "liquidity premium" which
reduces the costs of issuance and provides the incentive for firms to do so. This explains why
commercial paper exists and is issued almost exclusively by high quality credit risks. Issuing
firms have access to other credit markets but are willing to bear the transactions costs of
constantly rolling over short term debt as long as the “liquidity premium" outweighs the
transactions cost.’

Our focus in the next section of this paper is on differences across firms that are
associated with differential access to debt markets, and particularly, to markets for rated short-
term public debt (commercial paper) and rated long-term public debt (bonds). We sort firms
according to their access to long-term and short-term public debt markets and examine their
characteristics.

Consistent with the Gorton-Pennacchi view, and contrary to the incentive view, we find
that commercial paper issuers are of the highest quality, and present the least possible risk to
short-term holders of money-market instruments. While it is widely known that the commercial
paper market is used by many high-quality firms, ours is the first systematic study of which we
are aware that identifies the characteristics of issuers and non-issuers, and the determinants of
within firm variation in commercial paper issuance. Consistent with the incentive view, we find
that firms for which information problems are likely to be most severe have less access to public
debt markets. But the characteristics of firms that use the commercial paper market indicate that
short-term public debt is not used as a disciplinary device. Rather, access to commercial paper

markets is restricted to a small number of high-quality firms.

18

P D ENCE IAL ISS

Our data set combines quarterly data on commercial paper (ratings and amounts
outstanding) provided by Moody's with quarterly and annual accounting data obtained from
Standard & Poor’s Compustat. The data on commercial paper programs include all commercial]
paper programs rated by Moody’s from the second quarter of 1985 through the first quarter of
1992, so that at most 26 quarters of data are available for each firm. Our universe is the set of
all manufacturing firms (SIC codes 2000 through 3999) appearing on Compustat’s quarterly and
annuai files over the same time period, excluding subsidiaries and non-domestic firms. We do
not require a firm to have ali 26 quarters of data in order to appear in our panel. Instead, our
panel is "unbalanced" to allow for entry and exit. The above criteria generate an initial universe
of 3383 firms. Of these, 270 have data on commercial paper programs that are rated by
Moody’s.' Since smaller programs are often rated by only one agency, we use Compustat
data (Standard and Poor's ratings) to identify an additional 56 programs.'* Compustat data
were also used to identify firms that issue bonds.

Table 1 summarizes the frequency distribution of firms according to their long-term debt
ratings and access to commercial paper markets.’? Firms are grouped into five categories: AA
or AAA bond ratings, A ratings, B ratings, below B ratings, and no bond rating. The columns
of Table 1 further subdivide firms according to whether the composition of their public debt (if
any) consists of bonds or commercial paper or both.'© Of the AA or AAA firms, 94 percent
have commercial paper programs, while 82 percent of the A rated firms have commercial paper

programs. These numbers indicate that a high rating in long-term credit markets is a pretty good

19

indicator of access to commercial paper markets, but it is still the case that 25 percent of B-rated
firms issue commercial paper, illustrating that high long-term credit quality is by no means
necessary for access to commercial paper. At the lowest end of the quality spectrum, virtually
none of the firms with low or no bond rating have access to the commercial paper market.
Clearly, there is a close association between long-term credit quality and commercial paper
issuance, and the final row of Table 1 indicates that neither is particularly common: 20 percent
of the firms in our sample have access to long-term bond markets, while just 8 percent have
access to commercial paper markets.

Comparing the financial statements of issuers and non-issuers reveals some interesting
differences. Table 2 reports means of firm-level variables divided into the same three categories
as Table 1: firms with no bonds, firms with bonds but no commercial paper, and firms with both
bonds and commercial paper. There are important differences among the categories and in many
cases firms with bonds but no commercial paper appear as an intermediate category between
firms with both and firms with neither. The first obvious point is that commercial paper issuers
are much larger than non-issuers (measured here by quarterly sales). Commercial paper issuers
also have lower ratios to capital of sales, debt, inventories and financial working capital.
Finally, commercial paper issuers appear to have less volatile fundamentals, as indicated by their
lower standard deviations of the ratios of earnings-to-capital and sales-to-capital. (In all of the
above comparisons, the results are robust to using sales instead of capital as the scaling factor.)
The components of financial working capital that differ most across classes are cash assets and
Short-term debt; neither accounts receivable nor accounts payable account for much of the low

average working capital ratios of issuers. The results reported in Table 2 are also robust to

20

controlling for industry effects. We divided firms by two-digit SIC codes and generated Table
2 for each industry and the results were consistently the same.

The simple comparisons of means confirm our expectations about the character of firms
with access to the commercial paper market. First, the low sales-to-capital ratios of commercial
paper issuers (0.95 vs. 1.59 for those issuing neither bonds nor paper) may reflect Jower costs
of capital, which in equilibrium would imply more capital-intensive production. Or, it could be
that the capital-intensity of commercial paper issuers reflects the age and maturity of such finns,
where mature firms have reached their long-term desired levels of capital intensity. Second, the
lower standard deviations of the sales-to-capital ratios (0.17 vs. 0.42) and earmings-to-capital
ratios (0.04 vs. 0.11) of issuers are consistent with lower fundamental risk and thus higher credit
ratings. Third, commercial paper issuers hold lower stocks of inventories-to-capital (0.58 vs.
1.26), which like the sales-to-capital ratios may reflect differences in factor costs related to
capital market imperfections (more on this below). Fourth, the lower levels of financial working
capital (0.05 vs. 0.51) are particularly striking, and are consistent with the view that firms
maintain positive net levels of short term financial assets in order to compensate for inferior
access to credit. This implies that firms with access to commercial paper markets need not hold
precautionary savings. It also seems that access to bond markets reduces the need to maintain
large stocks of liquid assets.

Stocks of inventories and financial working capital relax financing constraints in
two ways. First, both are preferred forms of collateral for bank loans. Inventories (particularly
in the form of raw materials, which constitute the bulk of inventories) are easily appraised and

easily liquidated. Thus firms that depend on banks for credit may find it advantageous to select

21

material-intensive production techniques, or may be required by lending covenants to maintain
minimum amounts of working capital. Second, firms with high costs of externa] finance may
use financial working capital as a “self-insurance” device. If a firm knows that it will have
trouble raising funds, it may choose to accumulate financial working capital during high-earnings
periods so that it can draw down its war chest during low-earnings periods. To the extent that
there are costs to interrupting fixed capital investment, R&D, or even such financial activity as
dividend payments, this strengthens the firm’s incentive to accumulate buffer stocks of financial
working capital.

Recent empirical studies have confirmed the role of financial working capital as a self-
insuring device for finance-constrained firms. Kashyap, Lamont, and Stein (1992) find that
sensitivity of inventories to financial working capital is only apparent in firms without bond
ratings. Carpenter, Fazzari, and Petersen (1994) find that inventory responses to earnings are
larger for small firms than for large firms, which they interpret as evidence that finance-
constrained firms use inventories to offset fluctuations in earnings, and thus maintain smooth
fixed capital investment. Calomiris and Hubbard (1994) find that firms facing high costs of
external finance display the greatest earnings sensitivity of working capital to earnings, and that
the elasticity of working capital with respect to earnings is much higher than that of fixed
capital. In the next section we report similar findings of greater sensitivity of inventor and
financial working capital investment to earnings for non-issuers than for issuers. These facts --
like the comparison of means in Table 2 -- are consistent with the notion that constrained firms
accumulate financial working capital to increase their access to bank credit, and to insulate

capital and inventory investment from eamings disturbances.

22

We further investigate the connection between credit quality and working capital ratios
in Table 3, where we divide firms according to the five bond ratings categories described above.
As in Table 2, the pattern is monotonic in ratings. Inventory ratios and financial working capital
ratios increase as credit quality declines. The evidence in Tables 1 through 3 indicates that
commercial paper issuance and high long-term credit quality are closely associated. High bond
ratings and access to the commercial paper market are determined by very similar combinations
of fundamental firm characteristics.

We now tum to the question of whether the firm characteristics that permit access to the
commercial paper market are adequately summarized by its long-term credit rating, or whether
there are additional firm ‘attributes that distinguish short-term creditworthiness from long-term
creditworthiness. The four columns of Table 4 address this question with probit results that
predict: (1) access to the bond market, (2) a high bond rating, (3) the existence of a commercial
paper program and (4) a commercial paper program that is active. Because the regressors in
these probits are not strictly exogenous (e.g., access to commercial paper markets -- the
dependent variable in column 3 -- may induce firms to hold lower levels of financial working
capital), we view these probit results as a useful summary of the partial correlations in the data.
For example, the differences in means shown in Table 2 may be driven by differences in the
sizes of firms rather than differential access to capital markets. The probit results control for
this because firms size appears as an independent variable in the estimation.

The first column in Table 4 examines firm characteristics (averaging over time using
annual Compustat data for the sample period) associated with having rated long-term debt. Not

surprisingly, larger firms and firms with lower sales-to-capital ratios are more likely to have

23

long-term bonds. Perhaps more surprisingly, firms with bond ratings, ceteris paribus, have
lower levels of operating income, have higher standard deviations of operating income, are less
likely to pay dividends (presumably in part because they rely more on debt), and maintain higher
levels of accounts payable and receivable. The results on bond issuers’ characteristics give a
somewhat mixed picture, with perhaps the biggest puzzle coming from the dividend result, but
these results are not central to our focus, and so we turn to the determinants of commercial
paper issuance and bond quality.”

The second column in Table 4 measures factors that contribute to AA or AAA bond
rating. Not surprisingly, the highest quality bond issuers are large firms with low standard
deviations of earings and high average earnings ratios. They are also more likely to issue
dividends (possibly an indicator of low costs of external finance, as discussed in Fazzari,
Hubbard, and Petersen, 1988, and Calomiris and Hubbard, 1994), although the dividend variable
(which measures the percentage of years of positive dividends) is not statistically significant.

The last two columns in Table 4 consider factors that account for access to the
commercial paper market, after controlling for long-term credit quality using bond ratings. We
consider two measures of "access": first (in column 3), whether the firm has a commercial
paper rating during our sample period; and second (in column 4), whether the firm actually
issues any commercial paper during our sample period. Sixty of 253 firms with commercial
paper ratings issued no paper during the period. Interestingly, the results for the CP-rated firms
and the CP-issuing firms are different. The two probit models have many features in common -
- the coefficients on bond rating indicators, the importance of higher profits, larger size, higher

inventories, lower cash-net-of-debt, higher accounts receivable, and a greater likelihood of

24

dividend payments. But the standard deviation of earnings is insignificant for CP-rated firms
and highly significant for CP-issuing firms, after controlling for long-term debt quality. In other
words, volatile cash flow seems to force firms out of the commercial paper market rather than
into it.

The positive effect of inventories and accounts receivable in the commercial paper probits
is also interesting, given that on average (without controlling for size, long-term credit risk, and
profitability) commercial paper issuers hold smaller amounts of inventories and financial working
capital. It could be that firms with large inventories and accounts receivable use the commercial
paper market to give them greater flexibility in their short-term financing. It could also be that
short-term creditworthiness requires more stringent standards than long-term creditworthiness,
possibly because commercial paper serves as a money market instrument (as in Gorton and
Pennacchi, 1990). Thus part of the price of admission to the commercial paper market may be
the maintenance of more liquid assets. The probits are not able to distinguish cause from effect
in the relationship between paper issuance on the one hand and inventories and accounts
receivable on the other. Correlations that we report below, however, suggest commercial paper
is used to finance changes in inventories and net accounts receivable, and support the notion that
commercial paper provides flexibility for the financing of volatile short-term assets.

Recent research on the characteristics of firms that withdraw from the commercial paper
market has also drawn attention to the high quality standards imposed by holders of commercial
paper. Lucas and Noe (1989) and Fons and Kimball (1992) describe a process of “orderly exit"
in the commercial paper market. As commercial paper borrowers’ credit deteriorates, and they

receive a downgrading on their commercial paper, they exit from the market while still solvent,

25

and this typically occurs before any defaults on long-term debt. This evidence on orderly exit
complements our previous findings of high quality standards in the commercial paper market.
In Table 5, we report an “exit probit" as a function of firm financial condition. We
relate eamings and sales changes to the probability of exit from the commercial paper market,
where exit is defined to occur during a quarter that: witnesses a transition from a positive
outstanding amount of commercial paper to zero outstanding paper. We find a strong
relationship between lagged earnings and sales and exit from the market. Declines in either sales
or earnings increase the likelihood of exit with a four quarter lag. This lag likely reflects delays
associated with reporting earnings and sales data, and with waiting for outstanding paper to

mature.

EVIDENCE ON THE COSTS OF EXTERNAL AND INTERNAL FINANCE

According to standard finance theory, the benefit of low risk (high credit quality) is a
lower cost of raising funds. As discussed above, however, low risk may also reduce the
problems associated with asymmetric information, and for the very best firms, may permit
access to the commercial paper market where the firm may be able to pay even lower rates of
interest in exchange for supplying assets to the money market. The total return to a holder of
commercial paper will be the pecuniary retum plus the liquidity benefits from holding an asset
that is easily transformable into cash.

For firms that cannot gain access to commercial paper markets, the shadow costs of short
term funds may be considerably higher. As we discussed in the last section, the same

characteristics that allow firms access to commercial paper markets may also allow firms to reap

26

the gains from not having to carry excessive financial working capital. Firms with high costs
of external finance should not only carry higher average stocks of financial working capital, but
should also display greater sensitivity to cash flow. Constrained firms will draw working capital
down during low cash flow periods and accumulate it during high cash flow periods (Fazzari and
Petersen, 1993). Similarly, fluctuations in cash flow will affect the inventory investment of
constrained firms (Carpenter, Fazzari and Petersen, 1994).

To test these propositions, we first run regressions of inventories and financial working
capital on several lags of sales and earnings, estimating separate regressions for two subsets of
firms: those that issue commercial paper and firms that do not. In this case, by classifying firms
according to their access to commercial paper markets, we have identified a subset of firms for
which barriers to short-term credit are demonstrably low. According to the broad predictions
of the theory, such firms should have a lower cost of short-term funds, and therefore should
display lower sensitivity of inventory and financial working capital investment to cash flow.

These predictions are confirmed in the simple reduced-form results reported in Table 6.
These regressions use annual data to estimate the sensitivity of inventories and financial working
capital (scaled by fixed capital) to three lags each of the sales-to-capital and operating-income-to-
capital ratios. These regressions control for firm fixed effects by differencing the specification
and instrumenting using lagged regressors.'* A comparison of columns one and two reveals
much less cash flow sensitivity of inventory investment among firms with access to commercial
paper markets. In particular, the sum of the operating income coefficients for non-issuers ("No
CP") is 0.468 and statistically significant, whereas the sum of coefficients for commercial paper

issuers ("CP Issuer") is 0.013 and statistically insignificant. '°

27

We also estimate partial adjustment regressions for inventories using quarterly data.
These are reported in Tables 7a and 7b. The underlying specification (without the addition of
cash flow variables) assumes that firms have a long-term desired ratio of inventory to sales.
Assuming a Koyck stock-adjustment process, one can express log inventories as a function of
“lagged log inventories, log sales, and the log of the long-run target ratio.” In time series data,
the log target stock simply shows up in the constant term and poses no estimation problems.
But with firm-level data, it makes sense to allow this term to vary across firms. Rather than
apply standard panel data techniques such as differencing to condition on this term (see note 19).
we chose instead to exploit the length of our panel -- 26 quarters -- to estimate this target ratio
as the firm-specific mean of this ratio. These specifications are estimated using OLS and
reported in Table 7a. The estimates in Table 7b are identical except that they use 2SLS with
lagged regressors as instruments. This implies that the specification includes the expectation
rather than the realization of log sales.

Under the restrictions implied (but not imposed) by the model, the coefficients on lagged
log inventories and log sales should sum to one, and the coefficient on the log of the long-run
target ratio should equal the coefficient on log sales. While these predictions of the model are
not of direct interest to us, we note that they do not appear to be rejected by any of the
specifications reported in Tables 7a and 7b. We also note that the coefficient on log sales is the
partial adjustment parameter, and that these parameter estimates appear virtually identical across
subsets of firms and alternative specifications.

Adding earnings to these equations is a way to test for excessive responsiveness to

earnings in inventory accumulation, consistent with the buffer-stock view. We report three

28

specifications -- one with current operating income, one with both current and lagged, and one
including financial working capital in addition to operating income. In all cases, we find that
the sensitivity to operating income is greatest for firms without access to public debt markets.
Furthermore, these firms’ inventories are relatively sensitive to their lagged stock of financial
working capital. In Table 7b, the estimated effects are substantially larger for both classes of
firms, but are more pronounced and more precisely estimated for the "No CP" firms. These
results extend the results of Carpenter, Fazzari and Petersen (1994) and Kashyap, Owen and
Stein (1993) by demonstrating that access to commercial paper markets can be used to identify
firms for whom the short-term cost of funds is relatively low.

We view these regressions, and the research of others who have found similar effects,
as a Suggestive first step, not as conclusive evidence for the existence of excess buffer stocks
of working capital for finance-constrained firms. Nevertheless, these preliminary findings
suggest that commercial paper issuers enjoy a lower shadow cost of short-term funds than a

simple inspection of observed interest rates would reveal.

EVIDENCE MMERCIAL PAPER AND THE BUSINESS CYCLE
In light of the microeconomic evidence presented thus far, the countercyclical behavior
of commercial paper at the aggregate level is surprising. At the firm level, participation in the
commercial paper market -- as shown by Tables 2, 4, and 5 -- is positively associated with sales
and earnings. Additional evidence reported in Table 8 shows that the quarterly growth rates of
commercial paper and sales are positively correlated (0.141); that is, at the firm-level,

commercial paper issuance is “procyclical."?! Thus there is an apparent contradiction between

29

the procyclicality of commercial paper at the firm level and the countercyclicality of commercial
paper at the aggregate level. So why do bad economic times produce more commercial paper?
This section seeks to resolve this paradox.

We identify five possible explanations for the counter-cyclical behavior of aggregate
commercial paper issuance. First, Friedman and Kuttner (1993a) estimate VARs with aggregate
data that show commercial paper issuance responds positively to negative earnings impulses.
This suggests that firms may use commercial paper to offset earnings shortfalls. Second,
Kashyap, Stein, and Wilcox (1993) find that ratio of bank loans to bank loans plus commercial
paper (the "mix") is positively associated with various measures of economic activity. They
interpret this as evidence that firms substitute away from bank loans into commercial paper

during bank credit squeezes. Third, Gertler and Gilchrist (1993) find that large firms show

substantial increases in inventories and short-term debt around cyclical peaks, suggesting that

commercial paper (which is predominantly issued by large firms) may be financing the
countercyclical movement of inventories.

A fourth explanation for the countercyclical movement of commercial paper is the need
to finance trade credit. As the economy weakens, customers pay their bills more slowly and
firms may extend more trade credit as a means of financing their customers" short-term credit
needs. Because high-quality firms have easy access to short-term debt through the commercial
paper market, they in particular may serve as "intermediaries" for other firms experiencing
liquidity problems during business cycle downtums. Such high quality firms may allow their
customers -- who are experiencing contractions in earnings or increases in unanticipated

inventories -- to expand accounts payable, effectively providing a "pass through” of commercial

30

paper financing to the customers of commercial paper issuers.

Finally, it is possible that the increase in commercial paper during the onset of a
recession reflects changes in the portfolio demand of investors, rather than increases in the
demand for funds by issuers. “Asa low-risk, liquid asset, commercial paper may be in higher
demand during a recession (i.e, there may be a "flight to quality”). For example, if tight
monetary policy shrinks the supply of bank time deposits and CDs, this could shift demand to
other money market instruments, namely treasury bills and commercial paper. Shifts in portfolio
demand could also explain the countercyclical movement of the interest rate spread between
commercial paper and treasury bills (Friedman and Kuttner, 1993a, 1993b; Bernanke, 1990;
Stock and Watson, 1989): Because treasury bills are more liquid and less risky than commercial
paper, a flight to quality would cause commercial paper rates to fall by less than treasury bill
rates, thus explaining the movement of the spread.

The existing evidence using aggregate time series data cannot easily distinguish among
these five explanations. For example, Kashyap, Stein, and Wilcox (1993) argue that the
explanatory power of the "mix" (the ratio of bank loans to bank loans plus commercial paper)
in investment and inventory equations is evidence for the bank-credit-substitution hypothesis.”
However, Friedman and Kuttner’s (1993a) findings imply that any of the other mechanisms
mentioned above could explain the same negative association between aggregate economic
activity and commercial paper. They show that the predictive power of the mix is driven by the
quantity of commercial paper and that any negative shock to the economy -- not just those
associated with bank loan supply -- produces an expansion in commercial paper. Thus, any

explanation of the countercyclical movement of commercial paper can explain the behavior and

31

predictive power of the mix.

Our microeconomic findings are useful for distinguishing among the various explanations

for the countercyclicality of aggregate commercial paper. First, contrary to the hypothesis that
commercial paper is used to finance earnings shortfalls,
Table 8 shows that quarter-to-quarter changes in the ratio of commercial paper to capital are
positively (although somewhat weakly) correlated with changes in operating-income-to-capital
(0.058). The correlation between four-quarter changes is not statistically different from zero.
We also estimated OLS regressions (not reported here) with the change in commercial] paper as
the dependent variable, and found strong positive links between commercial paper change and
growth in eamings.

Second, contrary to the aggregate evidence reported by Kashyap, Stein, and Wilcox
(1993), the one-quarter and four-quarter changes in the ratio of commercial paper to total debt
are positively correlated with sales growth (0.149 and 0.089), inventory growth (0.017 and
0.157) and accounts receivable (0.088 and 0.133).% Thus, the bank-loan-substitution
hypothesis -- which views an increased reliance on commercial paper as an indicator of tight
credit conditions -- is inconsistent with the firm-level evidence.

Third, our data do provide support for the view that commercial paper is used to finance
inventory accumulation. The firm-level correlation between the growth rate of inventories and
commercial paper is 0.095 using one-quarter differences and 0.281 using four-quarter
differences. The correlation between the four-quarter growth rate of inventories and the ratio
of commercial paper to total debt (0.157) provides additional evidence that for firms that have

the option to issue, commercial paper is the marginal source of finance for inventory

32

accumulation.

Fourth, there is also evidence that commercial paper is used to finance trade credit. The
one-quarter and four-quarter correlations of commercial paper with accounts receivable are 0.108
and 0.182, respectively. It is also the case that the ratio of commercial paper to total debt is
positively correlated with accounts receivable (0.088 and 0.133, respectively), providing
evidence that commercial paper is the marginal debt instrument for financing accounts
receivable. It is interesting to note that the correlation between inventory changes and accounts
payable is relatively high for firms without access to public debt markets (0.13), but is
essentially zero (-0.004) for commercial paper issuers (not reported in Table 8). This is
consistent with a story in which firms without access to commercial paper, when hit with an
unanticipated increase in inventories at the onset of a recession, partly finance this by increasing
their accounts payable to firms with better access to short-term credit.

Finally, there is limited support for the view that commercial! paper issuance rises during
recessions in response to increases in the portfolio demand for liquid assets. Our
characterization of issuers showed that commercial paper is restricted to firms with strong
balance sheets and high cash flows; that is, firms that are in a position to supply low risk, highly.
liquid assets. With our data, we obviously cannot identify the extent to which demand shifts
contribute to the increase in commercial paper, but our characterization of the supply side of the
market is certainly consistent with such a story.

Our assessment of the above theories in light of our firm-level evidence leads us to the
following conclusions. First, it is essential to recognize differences across firms in order to

understand the aggregate movement of nonfinancial commercial paper. The commercial paper

33

aggregate is dominated by a very small number of firms whose large size, strong balance sheets,
and high cash flows put them in a position to issue low risk, highly liquid securities. There is
no evidence to suggest that such firms need to issue commercial paper in order to finance cash
shortfalls or reductions in alternative sources of short-term funds. But there is evidence that this
select group of firms uses commercial paper to finance increases in inventories and accounts
receivable. Among other things, this evidence calls for a more nuanced view of the apparent
substitution among assets in the aggregate. In particular, the movements of commercial paper
and bank debt may in fact reflect: (i) an increase in commercial paper to finance accounts
receivable among large, high credit quality firms acting as intermediaries for other firms, and
in tum (ii) the substitution of accounts payable for bank loans among smaller, “credit
constrained” firms. |

In conclusion, we identified five possible explanations for the countercyclical movement
of aggregate commercial paper issuance. Our evidence on the behavior of firms thal issue
commercial paper provides support for three of these explanations -- the need to finance
inventories, intermediation to credit constrained firms and the influence of demand for safe
assets.

The recent relationships among aggregate commercial paper, inventories and accounts

receivable of issuers (shown in Table 9) confirms our interpretation. As industrial production

Slowed prior to its peak in the first quarter of 1989, inventories, net accounts receivable and

commercial paper of the firms in our panel rose sharply as sales growth came to a halt. During
the recovery of 1991-1992, commercial paper fell as issuers’ inventories remained flat and their

net accounts receivable declined. Thus, our data set provides support for these hypotheses and

34
helps explain the paradox between the behavior of commercial paper issuers and the
macroeconomic data.
CONCLUSION

Counter-cyclical movements in aggregate commercial paper outstanding have been
observed for quite some time without being well understood. In this paper, we have used a
unique panel data set to explore the characteristics of issuers, the role of commercial paper as
a financing tool, and the relationship between the business cycle and commercial paper issuance
by firms.

We began with an examination of the characteristics of firms that issue paper and found
that access to the commercial paper market is restricted to firms of high credit quality.
Indicators of short-term credit quality (access to the commercial paper market) are closely
related to but not identical to the determinants of long-term credit quality. Holding constant
long-term credit quality, commercial paper issuers are larger, have high levels of collateral, have
higher earnings, lower earnings variance, and higher stocks of liquid assets. These
characteristics allow them to issue near riskless short-term public debt and enjoy a liquidity
premium by virtue of their ability to issue a money-market instrument.

Firms of high credit quality also behave differently than other firms. In particular, they
display excess sensitivity of inventory investment to fluctuations in cash flow, suggesting that
lack of access to commercial paper markets is an indicator of costly external finance due to
capital market imperfections. Consistent with this interpretation, we also found that firms of
high credit quality maintain much lower stocks of financial working capital, and exhibit much

less responsiveness of financial working capital to earnings. High credit quality permits these

35

firms to avoid excessive holdings of “buffer stocks" of financial working capital. The combined
evidence on the behavior of inventory and financial working capital investment indicates that the
shadow costs of funds attributable to capital market imperfections appear to be much lower for
high quality firms. This implies that the cost of short-term funds for commercial paper issuers
is more favorable than the low interest rates on paper would indicate.

Finally, our analysis of commercial paper issuers exposed a paradox that we sought to
resolve in the second part of the paper. The paradox arises because the countercyclical
movements of aggregate commercial paper are not the result of "countercyclical" issuance at the
firm level. In the aggregate, commercial paper outstanding tends to increase during economic
slowdown. However, our data indicate that for individual firms there is a positive relationship
between commercial paper issuance and their own sales or earnings. That is, at the firm level
commercial paper issuance is procyclical.

We concluded that there are three possible explanations of this apparent contradiction
between aggregate and firm-level behavior that are supported by our results. First, commercial
paper increases as a downtum begins becauses firms need to finance unplanned increases in
inventories. Second, firms that can issue commercial paper act as intermediaries for other firms
that may be credit constrained. Our evidence indicates that high quality firms increase their
accounts receivable during a downtum and finance these using commercial paper. Finally, it
may be that commercial paper issuance increases during a downtum due to an increase in
aggegate portfolio demand toward safe, liquid assets. This explanation is consistent with our

characterization of commercial paper issuers.

36

Table 1: Distribution of Firms over Bond Ratings and Debt Usage

Firm Classification by Debt Usage

No Bonds, Bonds, Both Bonds
Bond Rating No Paper No Paper and Paper
AAA or AA 0 4 60
A 0 23 103
B, BC or BBB 0 280 87
Other Rating 0 78 1
No Rated Bonds 2684 3 3
Total 2684 388 254
(%) (80%) (12%) (8%)

Notes: The sample universe is the set of U.S. manufacturing firms (3326) appearing on
Compustat over the period 1985 to 1991. A firm is classified as a bond issuer or
commercial paper issuer if it has a rating from either Moody's or Standard and Poor's
in any quarter between 1985-Q2 and 1991-Q1. Ratings classes are determined by the
average rating (calculated by giving numerical values to ratings).

37

Table 2: Firm Characteristics by Debt Classification, Quarterly Data. Table entries
are sample means of firm-year observations on levels and ratios, except for standard
deviations, which are firm observations.

Firm Classification by Debt Usage

No Bonds, Bonds, Both Bonds

Firm Characteristic No Paper No Paper and Paper

Sales 55.86 395.30 1521.50
Sales/K 1.59 1.21 0.95
OPINC/K 0.12 0.11 0.13
Sales Growth 0.01 0.02 0.01
FWC/K 0.51 0.36 0.05
FWC/Sales : 0.29 0.29 0.03
ACCPAY/Sales 0.32 0.32 0.36
ACCREC/Sales — 0.69 0.70 0.63
Net ACCPAY./Sales -0.37 -0.37 0.26
Inventories/K 1.26 0.86 0.58
Inventories/Sales 0.78 0.72 0.58
WCAP/K 1.89 1.32 0.63
WCAP/Sales 1.1 - 1.04 0.61
Short-Term Debv/K 0.39 0.25 0.20
CP/K 0.00 0.00 0.12
CP/(Short-Term Debt) 0.00 0.00 0.68
Long-Term Debt/K 0.60 1.09 0.61
Total Debt/K 1.09 1.41 0.85
Std(OPINC/K) 0.11 0.07 0.04
Std(Sales/K) 0.42 0.30 0.17
Number of Firms 2684 388 254

Variable Abbreviations: K=net stock of property, plant and equipment;
OPINC = operating income; WCAP=working capital; ACCPAY =accounts payable;
ACCREC =accounts receivable; FWC=financial working capital (working capital minus
inventories); Std(x)=firm-specific standard deviation of x; CP=commercial paper.

38

Table 3: Firm Characteristics by Bond Rating, Quarterly Data. Table entries are sampie
means of firm-year observations on levels and ratios, except for standard deviations, which are

firm observations.

Bond rating
No Rating Other B, BB, A AA or

Firm Characteristic Rating or BBB AAA

Sales 61.83 113.70 430.84 982.01 3524.55
Sales/K 1.58 1.37 141 0.99 0.93
OPINC/K 0.12 0.10 0.11 0.12 0.15
Sales Growth 0.01 0.01 0.02 0.0! 0.02
FWC/K 0.50 0.18 0.32 0.07 0.06
FWC/Sales 0.29 0.04 0.25 0.10 0.05
ACCPAY/Sales 0.32 0.37 0.34 0.34 0.33
ACCREC/Sales . 0.70 0.71 0.70 0.64 0.68
Net ACCPAY./Sales 0.37 0.34 -0.34 0.28 0.28
Inventories/K 1.25 1.01 0.77 0.65 0.47
Inventories/Sales 0.78 0.78 0.69 0.63 0.48
WCAP/K 1.88 1.34 1.16 0.72 0.54
WCAP/Sales 1.10 0.84 0.96 0.74 0.54
Short-Term Debt/K 0.39 0.40 0.21 0.19 0.25
CP/K 0.13 0.00 0.07 0.12) 0.15
CP/(Short-Term Debt) 0.74 0.00 0.60 0.76 0.64
Long-Term Debt/K 0.60 1.28 1.03 0.59 0.41
Total Debt/K 1.08 1.82 1.31 0.78 0.66
Std(OPINC/K) 0.11 0.09 0.06 0.04 0.03
Std(Sales/K) 0.42 0.38 0.26 0.16 0.11
Number of Firms 2700 79 367 126 64

Notes: See notes to Table 2 for details on sample selection and variable abbreviations.

39

Table 4: Cross-Section Probit Regressions for Debt Indicators. A value of one is assigned to
the dependent variables in columns one and three if the firm has a rating in any of the 26
consecutive quarters. The dependent variable in column two is assigned a value of one if the
average rating (calculated by converting to numerical ratings) is the range of AA to AAA.
Regressors are firm-specific means of ratios using annual data, except for the standard deviation of
operating income, which is calculated using quarterly data. Standard errors appear in parentheses.

Dependent Variable

Bond Issuer Bond Issuer CP Program CP Program

Regressors Any Rating AA or AAA and CP > 0
Intercept _. ~12.073 “37.813 “34,821 -33.070
(1.007) (7.492) (4.191) (4.567)
Std(OPINC/K) 3.379 -29.267 2.038 ~10.405
(1.694) (10.421) (4.390) (5.497)

OPINC/K 0.219 4.964 1.035 1.268
(0.191) (0.899) (0.465) (0.523)
Sales/K -0.226 0.768 -0.454 0.427
(0.090) (0.321) (0.163) (0.171)
(Sales/K)? 0.005 0.076 0.011 0.017
(0.006) (0.027) (0.012) (0.013)
Inventory/K 0.134 -2.754 0.996 0.965
(0.133) (0.843) (0.353) (0.400)
log(Sales) 2.933 6.805 7,761 7.134
(0.294) (1.652) (1.075) (1.149)
log(Sales) 0.145 -0.329 -0.445 0.397
(0.023) (0.094) (0.069) (0.072)
% Years with -0.718 1.064 0.932 0.512
Dividend > 0 (0.181) (1.008) (0.416) (0.465)
(Cash-S.T. 0.987 0.589 -3.54) -3.939
Debt)/Sales (0.334) (1.665) (1.459) (1.564)
ACCPAY/Sales 4.932 -3.100 -2.552 -2.025
(2.102) (6.098) (3.798) (4.046)
ACCREC/Sales 1.577 1.264 6.251 5.570
(0.966) (2.488) (2.029) (2.129)
Dummy= t if bond ves we 3.872 2.784
trating AA,AAA (0.758) (0.508)
Dummy= 1! if bond eee we 2.712 2.462
rating A (0.376) (0.389
Dummy=! if bond oe we 1.167 1.392
rating B,BB,BBB (0.299) (0.368)
Dummy = 1 if bond vee vee 0.686 -21.532
rated below BBB (1.090) ¢)

Notes: Sample size is 2298. For brief description of sample selection, see notes to Table !; for
variable abbreviations, see notes to Table 2.

40

Table 5: Probit Regressions to Predict Exit from the
Commercial Paper Market. Sample is selected by using
observations for which lagged CP is positive. Standard errors
appear in parentheses.

Dependent Variable — Exit

Value of 1 if
Regressors CP,,>0 and CP,=0,
Intercept -2.316
(0.185)
(OPINC/K),, 1.518
(2.972)
(OPINC/K),, 4.142
(3.260)
(OPINC/K)., -1.459
(3.407)
(OPINC/K), -7.172
(2.825)
(Sales Growth), -0.546
(1.068)
(Sales Growth), 1.066
(1.064)
(Sales Growth), 0.282
(1.044)
(Sales Growth), 2.826
(0.910)

Notes: Sample size is 2676. The number of exit events is
197. For variable definitions, see notes to Table 2.

41

Table 6: Inventory and Financial Working Capital Regressions, Annual Data. All specifica-
tions control for fixed firm and year effects. To control for firm effects, model is transformed to
first-differences and estimated with 2SLS using lagged regressors as instruments to control for
potential endogeneity induced by differencing if regressors are only weakly exogenous. Standard
errors appear in parentheses.

Inventory Investment FWC Investment
No CP CP Issuer No CP CP Issuer
Intercept -0.026 0.007 ‘0.017 0.000
(0.006) (0.006) (0.015) (0.015)
(Sales/K) 0.047 0.126 -0.143 0.114
(0.006) (0.013) (0.014) (0.032)
(Sales/K)., -0.045 -0.040 0.052 +0.016
(0.006) - (0.013) (0.014) (0.032)
(Sales/K)., -~0.020 0.005 0.024 40.001
(0.006) (0.012) (0.014) (0.029)
(OPINC/K) 0.231 0.010 0.762 0.096
(0.027) (0.068) (0.065) (0.16)
(OPINC/K), 0.141 0.091 0.314 * 0.145
(0.026) (0.066) (0.062) (0.158)
(OPINC/K)., 0.096 0.088 -0.172 0.123
(0.026) (0.061) (0.060) (0.143)
Adjusted R? 0.13 0.31 0.08 0.04

Notes: For brief description of sample selection, see notes to Table |; for variable abbreviations,
see notes to Table 2.

42

Table 7a: OLS Estimates of Quarterly Inventory Regressions. Dependent variable is the log of
inventories. Up to 26 quarters are used to obtain a consistent estimate (the sample mean) of the
firm’s long run inventory-to-sales ratio, a. The log of this variable is included to control for fixed
firm effects. Dummy variables are also included to control for fixed time effects, but are not
reported below. Standard errors appear in parentheses.

Firm Classification

No CP CP Issuer
Regressors Model! Model 2 Model 3 Model 1 Model 2. Model 3
log@.: 0.522 0.533 0.501 0.225 0.224 0:223
(0.008) (0.009) (0.009) (0.027) (0.027) (0.027)
log(S) 0.479 0.469 0.499 0.779 0.780 0.781
(0.009) (0.009) (0.009) (0.027) (0.027) (0.027)
log(c,) 0.453 0.447 0.475 0.777 0.778 0.782
(0.009) (0.009) (0.009) (0.028) (0.028) (0.028)
(OPINC/S) 0.257 0.262 0.109 0.006 0.010 0.468
(0.022) (0.022) (0.025) (0.074) (0.075) (0.158)
(OPINC/S)., 0.164 0.548
(0.014) (0.161)
(FWCY/S)., 0.080 -0.010 0.010
(0.008) (0.037) (0.037)

Notes. For brief description of sample selection, see notes to Table 1. Variable Abbreviations:
log()=log of inventories; log(S)=log of sales; log(a,)=1og of the firm-specific inven-tory-to-sales
ratio, OPINC/S =operating-income-to-sales ratio; FWC/S =ratio of financial working capital to

sales; CP=commercial paper.

43
Table 7b: 2SLS Estimates of Quarterly Inventory Regressions. Dependent variable is log(1), the
log of inventories. Up to 26 quarters are used to obtain a consistent estimate (the sample mean) of
the firm’s long run inventory-to-sales ratio, a. The log of this variable is included to control for
fixed firm effects. Dummy variables are also included to control for fixed time effects, but are not
reported below. Standard errors appear in parentheses.

Firm Classification

No CP CP Issuer
Regressors ‘ Modell Model 2 Model 3 Model 1 Model 2° Model 3
log®,., 0.729 0.791 0.742 0.722 0.717 0.719
(0.016) (0.022) (0.018) (0.077) (0.078) (0.084)
log(S) 0.257 0.206 0.233 0.275 0.279 0.279
(0.016) (0.021) (0.019) (0.077) (0.079) (0.085)
log(a,) 0.235 0.204 0.224 0.264 0.268 0.267
- (0.018) (0.021) (0.020) (0.080) (0.081) (0.087)
_(OPINC/S) 0.751 0.618 1.532 0.321 0.396 0.223
~ (0,046) (0.058) (0.164) (0.102) (0.132) (1.085)
(OPINC/S), vee a -0.230 ves a 0.088
(0.046) (0.982)

(FWCIS), wee 0.438 we _ 0.178
(0.089) (0.194)

Notes: For brief description of sample selection, see notes to Table 1. Variable Abbreviations:
log@=log of inventories; log(S)=log of sales; log(a,)=log of the firm-specific mean of the
inventory-to-sales ratio; OPINC/S=operating-income-to-sales ratio; FWC/S =ratio of financial
working capital to sales; CP=commercial paper.

Table 8: Firm-Level Correlations with Commercia) Paper, Quarterly Data.
Calculations are based on variables transformed by differencing (indicated by 4).

One-Quarter Four-Quarter

Variables Differences Differences

4 (CP/K)
a(OPINC/K) 0.058" 0.030
a(Sales/K) 0.124" _ 0.007
a (INV/K) 0.072" 0.121
a(ACCPAY/K) -0.022 0.027
a (ACCREC/K) 0.125" 0.104"
a(Net ACCREC/K) 0.1307 0.1177

alog(CP)
alog(Sales) 0.141™ 0.1567
alog(INV) 0.095 0.2817~
alog(ACCPAY) 0.003 0.113°™
alog(ACCREC) 0.166~ 0.235"

4(CP/Total Debt))
alog(Sales) 0.149 0.0867"
alog(INV) 0.017 0.1577
alog(ACCPAY) -0.004 -0.000
alog(ACCREC) 0.088" 0.133°°

Note: Correlations marked by * are significantly different from zero at the 5% level,
by ** at the 1% level, and by *** at the 0.1% level. Sample size is approximately
3000, depending on the variable pair. The selection of observations into the sample is
conditional on commercial paper being positive in both the current and the relevant
lagged quarter. Similar results are obtained when only one of either the current or
lagged value was required to be positive. Variable Abbreviations: K=net stock of
property, plant and equipment; OPINC =operating-income-to-sales ratio;
ACCREC=accounts receivable; ACCPAY =accounts payable; INV=inventory stock;
NVX=inventory expenditures.

45

Table 9: Aggregate Quarterly Time Series (nominal) for Commercial Paper Issuers,
Selected Variables. Aggregates constructed by summing over “commercial paper issuers"
without missing data for the period shown.

Year Qtr cP Sales INV ACCPAY ACCREC LT Debt

1988) 1 23814 244976 124898 101420 141822 162356
2 27511 258816 126305 105248 144052 169016
3 25982 258021 129654 103657 146300 177503
4 31940 273731 131518 110162 163224 193612
19891 35890 264295 134552 108976 164001 198493
2 43528 283410 134248 109530 168744 204282
3 48030 277437 137271 112251 174728 215962
4 47460 297661 137698 126702 180328 222801
1990 «61 50415 290140 143128 121331 183642 229749
2 57629 300034 143791 121057 186143 232340
3 53939 313551 149623 134435 200260 238253
4 49192 350399 146960 143319 199710 238816
199 1 45188 303682 149318 12748] 188329 241889
2 42032 305368 145787 127484 — 187334 242116
3 41581 306393 147523 128843 190237 241747
4 36595 328480 145514 140467 195945 239525
1992 1 30368 300979 147700 129409 189299 235535

46

Chart 1

Ratio of Nonfinancial Commercial Paper to GDP

0.03
0.025-
0.02~
0.015-
0.01-

0.005-

Te

TUUPTUCURUSTTESTTTETTUTTIT EO TS TET TTT Tirrrci rer ivit iit iti it Tit ii it titi i rT ititit i itit st TTT

69 71 73 #75 677 679 81 83 8 87 89 91

70 72 74 76 78 80 82° 84 86 88 90 92

47

Chart 2

Nonfinancial Commercial Paper At Business Cycle Peaks

1.7
1.6-
1.55
1.45
1.37

Nov. 1973

“July 1981

— Ho

- a
ee July 1990

654321012345 67 8 9 1011 121314151617181920
Months from Cycle Peak

48

Chart 3

Ratio of Bank Loans to Credit Market Debt
‘0.31

0.3-

0.297

0.287

0.27-

0.26-

0.257

0.24-

0.234

53 58 63 68 73 78 83° "88

49

0.06

Chart 4

Ratio of Commercial Paper to Credit Market Debt

0.05-

0.04-

0.035

0.02-

0.017

53 58

PECPGGSUSCRITISTITIINTIOIASIPERLLIDOUUERCLTTMELSISUTIPSIPLLSUL GLE STIC ATIC EE IES AE TAIT ORE RUT LBCUULESECOU LAS

350

NOTES

1. More generally, business cycle analysts have been aware of the countercyclical behavior of
commercial paper issuance since Selden (1963).

2. Earlier studies that pre-date the growth of the commercial paper market have noted cyclical
patterns in trade credit and the role of inter-firm intermediation (Davis, 1960; Meltzer, 1960
and Seiden, 1964). Meltzer (1960) shows that in periods of monetary tightening, large, liquid
firms increase the amount of trade credit extended. They act as financial intermediaries to
smaller firms that might have been rationed out of other sources of financing. By providing
financing, the liquid firm can maintain demand and customer relationships in the face of a
slowdown. More recently, Smith and Schnucker (1994) explore the empirical determinants of
trade credit and its financing.

3. Mian and Smith (1992) make a similar argument. They indicate that firms form finance
Subsidiaries to finance accounts receivable and provide financial flexibility, often through
commercial paper issuance.

4. The data on commercial paper ratings and amounts outstanding were graciously made
available by Jerome Fons.

5. These findings are consistent with recent research that suggests that high costs of external
finance related to asymmetric information and governance (rather than to risk, per se) lead firms
to self finance, and to "self-insure” against declines in earnings by maintaining large stocks of
liquid assets (Carpenter, Fazzari and Petersen, 1993; Calomiris and Hubbard, 1994).

6. Of course, local banks still helped finance commercial paper by providing bridge loans to
local commercial paper houses.

7. Recall that commercial paper is held almost exclusively by banks during the early period, but
in the later period, is held outside of banks. This distinction is important, and can create
problems for macroeconomists who use the ratio of commercial paper to bank loans historically
as an indicator of the relative size of "bank" credit.

8. We will examine the distribution of CP and bond ratings in our data set in the section below
that describes the data.

9. The data were obtained from Citibase. Nonfinancial commercial paper (series FCPNF) is
from the Federal Reserve Bank of New York.

10. Fees for all industrial bond issues of greater than $100 million average less than one
percent, but are much lower for the typical issues of highly rated firms (Cohan, 1961; Hansen
and Torregrossa, 1993).

11. — Interest rate spreads provide some indication that commercial paper is a highly liquid,
low-risk security. Interest rates on commercial paper and bank CDs move together very closely
for the past 20 years. For 3 month rates, the spread exceeds 40 basis points only during the
periods of high interést rates around the first oil price shock and again in the early 1980s. The

51

spread has been less than 20 basis points since the end of 1984. Indeed, given the close
correspondence between rates on CDs and commercial paper, it is surprising that the Federal
Reserve places the two assets into different monetary aggregates. CDs are included in the
definition of M3, while commercial paper is included in L, but not in M3.

12. Schnure (1994) introduces the idea of a clientele effect in the commercial paper market
which can be interpreted as a liquidity premium for near riskless debt.

13. There were about 15 firms with more than one program. For these firms we assigned the
rating of the largest program to the firm and used the sum of all programs. In most cases, the
outstanding of all but one program were zero.

14. For these firms, commercial paper outstanding are not available since this is not a data item
on Compustat. These firms make a relatively small contribution to the sample of paper issuers.
In the second quarter of 1985, there were 45 such firms with aggregate sales amounting to 9.6%
of the total sales of firms with commercial paper programs and 5.2% of the total sample.

15. The bond and commercial paper ratings prepared by Moody’s, Standard and Poor’s and
others are enormously important in determining access to capital markets and the cost of capital.
The ratings are derived from an informal analytic framework that weighs numerous factors
including many subjective judgments.

For example, the rating criteria for Standard and Poor’s industrial bond ratings includes
business risks and financial risks (see Standard and Poor’s, 1992). Business risks can further
be divided into industry characteristics (prospects, competition) and issuer characteristics
(diversification, market share, evaluation of management). The analysis of business risk
determines the financial risks appropriate for a given rating. Financial risk is measured
quantitatively with a great reliance on financial ratios. These include profitability (return on
capital), capital structure (e.g. debt-equity ratio), off balance sheet liabilities, cash flow adequacy
and financial flexibility. Commercial paper ratings are largely based on the same information
and are, therefore not surprisingly, closely related to bond ratings. Greater emphasis is placed
on liquidity considerations in determining the commercial paper ratings.

16. We do not distinguish among commercial paper ratings since virtually all paper receives the
top rating.

17. The results on dividend payments are included primarily to allow comparisons with papers
in the literature that have used low and infrequent dividend behavior as well as bond ratings to
identify firms with restricted access to capital markets. The results in Table 4 do not necessarily
favor one over the other, and it is important to remember that these results are conditioned on
size and capital intensity. Simple correlations would undoubtedly reveal a much closer
correspondence between dividend payments and bond usage.

18. Regressions with quarterly data are found in Tables 7a and 7b. Results similar to those in
Table 6 also hold for quarterly data, but are more sensitive to the data transformations and
instrumental variable methods used to contro! for fixed effects.

52

19. Strictly speaking, unless the impact of investment on the sales and income ratios is zero,
summing the coefficients gives the wrong measure of the cash flow effect because it fails to
capture feedback effects. But to the extent that these effects are small and/or similar across
samples, it clearly gives a good first-order approximation. It is also possible that the coefficients
overstate the financing impact of cash flow since cash flow is also a predictor of future returns
to the investment (even with the inclusion of sales as a control). This point receives a formal
treatment in Gilchrist and Himmelberg (1993).

20. Specifically, the partial adjustment framework that we estimate allows the target ratio a;
of the inventory-to-sales to vary across firms, so that

Ii, = aS,e%,

where Ij, is the desired stock of inventories and S, is sales. We assume a partial adjustment
specification of the form:

(log Ij, ~ log I.) = Adlog Fj, - log I.) + uy
so that the final specification is:
log I, = (1 - A)log I,, + » log S, + d log a; + A & + UK.

We estimate the log target ratio, log(a,), for each firm using:

26
= XY (leg 2, - log 5,,).
t-1

21. In computing these correlations, we exclude from the analysis observations of zero

outstanding paper. Thus, our correlations only apply to changes in commercial paper in which

the beginning and end period values of commercial paper are both positive. When we left in

the zero-value observations, the correlations were qualitatively identical, but smaller, as many
“zero” firms showed no change over long periods.

22. Gertler and Gilchrist (1994) and Oliner and Rudebusch (1993) argue that the "representative
firm" metaphor employed by Kashyap, Stein, and Wilcox (1993) oversimplifies the effects of
tight bank credit because it does not discern differences in the response of large vs. small firms.

23. We cannot construct the exact mix variable used by Kashyap et al. because we do not have
the amount of bank credit outstanding at the firm level. Thus, we use total debt instead.

53

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