Defying Gravity — Why Corporate Loans Increase When Interest Rates Rise

In March of 2023, three large US banks collapsed, and central banks across Europe scrambled to prevent other large lenders from meeting the same fate as bank failure became a global concern. Of course, financial institutions weren’t the only ones affected by rising interest rates. As borrowing costs climb, companies are often forced to make difficult decisions, reducing staff and delaying new projects. 

Monetary tightening often leads to an expected contraction in aggregate corporate bonds but an increase in business loans that seems counterintuitive. For her doctoral thesis, Gies instructor Yuchen Chen decided to explore this puzzling phenomenon and understand why this one particular trend defies the gravitational pull that brings everything else to the ground.

In “Monetary Policy, Debt Structure and Credit Reallocation”, Chen examined the aggregate time series data from different debt markets, then looked at firm-level data to get a better picture of what was actually happening on the ground when rates begin to rise. For small- and mid-sized companies, Chen observed exactly what you’d expect. As rates rose, smaller companies signaled a retreat, reducing their borrowing from the bank. But all companies are not created equal. And even in hard times, there are always some who manage to swim against the tide.

“The top 10 percent of companies based on firm size, actually increase their use of bank loans when the interest rates rise,” said Chen, explaining that this happens for a few different reasons. First, large companies like Apple and Microsoft simply have more borrowing capacity than other firms, and second, they have a lot of profitable projects they want to maintain. “It’s very costly to reduce these investments immediately,” added Chen. So instead, they make strategic investments in projects that will serve them well down the road.

But there’s another factor driving the sudden expansion of loans, according to Chen, and that’s the rising cost of bonds. In better financial times, large companies often rely on bond sales to finance major projects. When rates rise, so does the cost of bonds, eventually making bank loans the more attractive option for large firms.

“They substitute more expensive bonds with bank loans when rates go up, even though those bank loans become more expensive,” said Chen, which means that the spike may not be an increase in borrowing as much as it is an adjustment, as large companies switch from one source of capital to another.

All of these trends lie within the realm of macroeconomics, which is Chen’s particular passion. “I like to study how macro policy affects financial markets and how that shapes firms’ borrowing decisions.” Those policies are largely driven by the Federal Reserve System, which sets the prime lending rate. Prior to completing a PhD in finance at the University of Minnesota, Chen got an inside look at two of the banks in that system, working as an economic analyst at the Federal Reserve Bank of Kansas City and completing a PhD dissertation fellowship at the Federal Reserve Bank of New York.

As a teacher, she hopes to continue her research, which is one of the main reasons she decided to come to Gies. “I like the research environment here,” said Chen. “Gies has a large finance department with more than two dozen faculty focusing on different areas.” And that opens the door to a lot of exciting collaborative opportunities.

Of course, impactful research requires strong support, and Chen says she sees that at Gies as well, from research funding to policies that make it easy for new faculty to acclimate to their new role. “Gies is very generous to the young researcher,” said Chen. “Also, even though Gies is in a small, peaceful college town, it’s never isolated. There are many excellent research universities here in the Midwest, like UChicago, Northwestern, Indiana, St. Louis, Purdue, etc. The annual Wabash River Finance Conference brings together many good researchers, and it’s a wonderful opportunity to present and discuss research with other researchers.”

Chen says she also looks forward to the research seminars at Gies, which attract speakers from other universities and promote the exchange of ideas. Together, all of these factors create an environment that will help take her research to the next level. “I’m looking forward to having discussions and working with people here,” said Chen. “That’s the most exciting part.”