Low firm productivity: the role of finance and the implications for financial stability

Prepared by Desislava Andreeva, Vasco Botelho, Alessandro Ferrante, Lucyna Górnicka and Francesca Lenoci

Published as part of the Financial Stability Review, November 2024.

Many factors – economic, financial and structural – shape firm productivity. This special feature zooms in on the role played by finance and the allocation of capital across firms. Aggregate productivity, access to credit and financial stability are closely interlinked. Inefficient allocation of capital can reduce the productive capacity of the economy, leading to subdued income growth and lower financial resilience for all sectors. While euro area firms rely mostly on bank lending to satisfy their funding needs, banks do not generally have a strong track record in distinguishing between more and less-productive firms, as their expertise lies in the assessment of credit risk. They tend to lack the skills needed to evaluate early-stage technologies and hesitate to finance risky innovations that involve intangible assets or other assets that are hard to collateralise. Financial markets and equity investors may be better suited to financing novel but risky projects. A more diversified external funding structure, including further progress on the capital markets union, could help boost the productivity of euro area firms, to the benefit of financial stability.

1 Aggregate productivity matters for financial stability

Access to external funding helps firms grow their business and become more productive. Productivity is an indicator of economic performance that measures the amount of output created for a given set of inputs, typically labour, capital, raw materials, and energy. As such, productivity developments are the key determinant of potential output growth in the economy and are the principal source of improvements in living standards. Productivity differences across firms can partly explain why some firms are able to grow and gain market share while others fail and are forced to exit the market.^[1] Access to finance can play an important role, as the effect of productivity-enhancing investments usually depends on whether firms can secure sufficient external funding, including through bank loans. It follows that the way funding is allocated can also affect which firms enter and which firms exit the market.^[2]

This special feature analyses the role of finance in driving firm productivity dynamics in the euro area and the implications for financial stability. Productivity, access to credit and financial stability are closely linked. The inefficient allocation of credit across firms or a lack of external financing for particularly innovative and productive companies affects the productive capacity of the economy as well as financial stability (Figure B.1).^[3] There is a direct, cyclical channel related to bank intermediation. If bank loans flow towards less-productive firms, bank asset quality and profitability are more likely to suffer in any downturn. Financial stability can also be affected indirectly. For example, capital being a scarce resource, more-productive firms may find it challenging to expand their business if bank funding is diverted to other companies (a crowding-out channel). This is a concern in bank-centric financial systems like the euro area where access to market-based funding might be difficult, especially for smaller and younger firms.^[4] Moreover, the resulting higher market share enjoyed by weaker firms can reduce profits for would-be productive competitors, discouraging entry into the market and investments (a congestion channel). This can suppress economic growth over the medium to long run. Ultimately, financial stability is likely to suffer from a banking system which has weaker asset quality and high debt levels as well as, overall, less-productive firms, coupled with subdued economic growth and therefore lower incomes for all sectors of the economy. Against this background, this special feature analyses the allocation of bank credit across sectors and discusses the role of equity finance. It then zooms in on the flow of bank funding to firms within the same industry, distinguishing between more-productive and less-productive companies.

Figure B.1

Transmission channels between credit allocation, productivity and financial stability

2 Euro area productivity growth has been declining for over 30 years

The aggregate productivity growth gap between the euro area and the United States has been widening since the mid-1990s. The main indicator of production efficiency in an economy is total factor productivity (TFP), which measures how much the average firm can produce for a given combination of inputs. As such, TFP captures the level of efficiency (or technology) employed by firms in the production process. It also captures unobserved characteristics that influence efficiency, such as management quality, digitalisation, and human capital accumulation. Focusing on the last 30 years, the average annual growth rate of labour productivity (real GDP per hour worked) in the euro area declined from 1.6% between 1995 and 2001 to 0.3% between 2019 and 2023 (Chart B.1, panel a). The main drivers of this were a capital-to-labour ratio that had stagnated since the sovereign debt crisis and a declining contribution from TFP growth. Although the US economy also experienced a productivity slowdown over the same period (Chart B.1, panel b), average labour productivity growth was significantly lower in the euro area. Moreover, between 1995 and 2023, TFP increased by just 18% in the euro area but by 33% in the United States (Chart B.1, panel c). The widening of the TFP gap versus the United States, together with less support from capital deepening, resulted in the euro area gradually becoming less and less competitive than the United States.

Chart B.1

Slowing TFP growth has contributed to declining labour productivity growth in the euro area and to a productivity growth gap versus the United States

a) Drivers of euro area labour productivity growth	b) Drivers of US labour productivity growth	c) Cumulative TFP growth since 1995
(1995-2023; annual percentage change, percentage point contributions)	(1995-2023; annual percentage change, percentage point contributions)	(1995-2023, percentages)

Lower growth in the euro area than in the United States for technology-intensive and innovative sectors is one driver of the widening productivity gap. The technology-intensive ICT sector is the sector that has made the most significant contribution to the widening TFP growth gap between the euro area and the United States.^[5] Between 1999 and 2019, the ICT sector increased its weight by 5.2 percentage points in the US economy but by just 2.4 percentage points in the euro area economy (Chart B.2, panel a). At the same time, TFP in the ICT sector grew by 80% in the United States and by 43% in the euro area, widening the TFP growth gap in the sector by 37 percentage points over this period (Chart B.2, panel b). The relative weakness of the ICT sector in the euro area can also affect innovation in adjacent highly-innovative sectors that benefit from state-of-the-art digital technologies, such as pharmaceuticals or defence.^[6] This increases the risk of the euro area lagging behind in sectors of strategic importance.^[7] The relatively broad-based sluggish productivity growth in the euro area across sectors – trade and construction being the only notable exceptions – has prompted a search for potential explanations, including the role of access to finance.

Chart B.2

The widening TFP growth gap between the euro area and the United States has largely been driven by the ICT sector

a) Sectoral changes in real value-added shares	b) Sectoral TFP growth gap between the euro area and the United States
(1999-2019, percentage points)	(1999-2019, percentage points)

3 Euro area firms are strongly bank dependent

Most euro area firms rely mainly on bank intermediation as an external source of financing. At the end of 2022, in terms of total non-financial corporation (NFC) sector assets, only around 20% of firms operated without any form of bank funding (Chart B.3, panel a). These firms probably use only internal funds because, in contrast to the United States, it is rare for euro area firms to fund themselves exclusively via financial markets.^[8] Roughly 22% of euro area firms with more than 20 employees tap the bond market, besides obtaining bank loans. Even for large, listed firms with access to debt markets, bank loans are the main source of credit and represented, on average, 58% of total external funding at the end of 2022.

Chart B.3

Bank lending to real estate firms vastly exceeds their share in gross value added

a) Size of euro area corporate sector and share of assets financed by bank credit	b) Sectoral contributions to real value added and to banks’ corporate exposures in the euro area
(2022; left-hand scale: total assets, € trillions; right-hand scale: percentages)	(2022; bottom axis: € billions, top axis: percentages)

A significant share of bank lending in the euro area is directed towards the real estate sector, which contributes only marginally to TFP growth. The real estate sector, the wholesale and retail trade and the construction sector have a much larger share of the banking sector’s aggregate corporate loan portfolio than is warranted by their contribution to gross value added (Chart B.3, panel b). This may reflect their high external financing needs given their longer production cycles (e.g. for the investment-heavy construction of new buildings). It may also be because sectors whose tangible assets are generally accepted as collateral have better access to credit. Nevertheless, the large, disproportionate exposure stands out, particularly in the case of the real estate sector.

Even within sectors, euro area banks lend to less-productive firms. Following an estimation of firm-level TFP, the productivity levels of firms which do not rely on bank loans were compared with those of firms which do.^[9] The dots in Chart B.4, panel a) represent granular two-digit NACE (NACE2) sectors located in each euro area country. The graph shows that firms with bank funding are generally less productive than competitors which do not rely on bank loans as a source of external funding. To some extent this could reflect differential access to bank funding between firms which rely on tangible assets versus those which rely on intangible assets. Indeed, the differences in estimated TFP levels between firms which use bank loans and those which do not are larger in sectors such as ICT or professional, scientific and technical services compared with manufacturing or construction. These differences in average productivity levels do not seem to reflect the impact of a few large firms: for most sectors and countries, both the bottom 20% and the top 20% of the TFP-level distributions are lower for firms with access to bank lending than for firms without bank loans within the same NACE2 sector (Chart B.4, panel b).

A more diversified external funding structure could be one reason for the productivity gap between the euro area and the United States. Equity markets may be better able to finance innovative but potentially risky projects.^[10] First, equity holders benefit fully from improvements in firm productivity while the upside for creditors is capped at the level of the outstanding principal amount plus the applicable interest rate. Equity investors may therefore have a greater incentive to screen for particularly innovative and productive firms. Second, the relevant time horizon for banks may be too short since it is linked to the typical loan maturity, while equity holders also benefit from improvements in firm performance over the long run. Third, banks may be hesitant to finance innovations that involve intangible assets or assets that are firm-specific and hard to collateralise.^[11] Finally, unlike venture capital firms, banks may lack the skills to evaluate early-stage technologies or, unlike private equity firms, they may lack the ability to intervene directly and improve the operational efficiency of existing firms.^[12]

Chart B.4

Firms with bank loans show lower average productivity than their competitors without bank loans

a) Average TFP level among firms with and without bank loans at NACE2-country level	b) Distribution of TFP levels among firms with and without bank loans, by NACE1 sector
(2019-22, log TFP levels)	(2019-22, log TFP levels for selected NACE1 sectors)

US firms can tap a developed equity market which channels resources towards firms with long-term growth potential, while euro area companies find it more difficult to access equity finance. As of June 2024, the market capitalisation of euro area corporates amounted to €7.8 trillion, representing 53% of GDP (this percentage is three times as high in the United States). In addition to higher equity issuance (Chart B.5, panel a), the US equity market is also characterised by a larger share of issuance by more-productive and riskier sectors such as ICT.^[13] The US private equity market is also more mature, with a net asset value of €3.33 trillion as of June 2023 (versus €0.43 trillion for the euro area). Its venture capital segment, which usually allocates funding to startups with the potential for substantial and rapid growth, also appears more advanced than that of the euro area (Chart B.5, panel b).

Chart B.5

US listed and private equity markets are more developed than those of the euro area

a) Equity issuance in the euro area and the United States, by year	b) Outstanding value of the venture capital market in the euro area and the United States
(2015-24; € billions, percentages)	(2023; € billions, percentages)

Market debt financing also plays a much smaller role as a source of NFC funding in the euro area. At the end of June 2024, debt securities represented 21% of total NFC sector debt in the euro area, compared with 39% in the United States. Enhanced credit market depth has a positive influence on TFP by improving price discovery, thereby facilitating more efficient investments. In addition, it can alleviate financial constraints, particularly during economic downturns. It can also reduce the cost of debt financing by lowering intermediary expenses and distributing risk more effectively among investors.^[14] In line with this reasoning, an analysis of the firm-level TFP of large euro area and US listed firms has shown that firms within the top 30% of the TFP level distribution have higher market debt ratios than the rest of firms in both regions (Chart B.6, panel a). This positive relation holds for the pre-pandemic period and when controlling for firm size and a range of other firm characteristics. However, looking at a broader sample of firms in the euro area (which also includes non-listed companies) shows that this pattern might be driven by companies in the manufacturing sector, while in ICT and for professional activities productivity levels and to the use of bond funding appear to be unrelated (Chart B.6, panel b).

Chart B.6

Firms with a greater reliance on market debt funding tend to be more productive, but the pattern varies across sectors and firm sizes

a) Market debt ratio of low and high-productivity firms in the euro area and the United States	b) Weighted average TFP level for firms with and without market-based funding at NACE2-country level
(2022, percentage points)	(2019-22, log TFP levels)

4 The pandemic exacerbated bank lending to less-productive firms

Given how important bank lending is to euro area firms, the role of firm productivity in lending decisions and its impact on bank balance sheets warrant closer analysis. The remaining part of this special feature looks at the bank characteristics that are associated with lending to low-productivity firms. It then explores whether this pattern is driven by the supply of funding from banks or by differences in the external financing needs of firms. Finally, it investigates the role of government guarantees in directing lending towards less-productive firms during the pandemic. The analysis focuses solely on the euro area banks and firms.

Lending to low-TFP firms is associated with notably weaker bank asset quality but stronger capital and liquidity buffers. Banks with larger credit exposures to low-TFP firms show worse asset quality, measured using both backward-looking metrics such as the NPL ratio and forward-looking metrics such as probabilities of default on performing exposures (Chart B.7). Such banks also have somewhat lower profitability. The patterns are consistent with the direct, cyclical channel, through which productivity affects financial stability. By contrast, the regulatory capital ratios of banks which lend more to low-TFP firms tend to be somewhat higher and their liquidity buffers significantly higher. Several factors could explain these higher buffers. For example, banks with a customer base consisting of less-productive firms may hold a larger portfolio of liquid securities because of weaker lending opportunities. In addition, lending to low-TFP firms is more prone to unexpected losses, meaning that banks which lend predominantly to such firms may wish to hold higher capital or liquidity buffers to manage credit risk in their loan books.

Chart B.7

Banks lending relatively more to less-productive firms have worse asset quality than banks lending more to more-productive firms

Bank balance-sheet characteristics and lending to low-productivity firms

(2019-22, percentages)

Making use of granular loan-level data, this analysis explores whether bank credit in the euro area is tilted towards less-productive firms. In the econometric framework used, a set of bank-firm level regressions explains the supply of bank credit to individual firms, depending on their productivity levels. Bank credit is measured by new loans from bank j to firm i, scaled by total firm assets.^[15] The main explanatory variables feature a firm-specific indicator of a low TFP level plus a range of bank characteristics and their interactions. Fixed effects at the level of country-industry-firm size-time are included to control for loan demand. Within this framework, a positive and statistically significant coefficient on the low-TFP indicator would imply that, all else equal, less-productive firms receive more bank credit than other firms.

The results suggest that during the pandemic, bank lending tilted towards less-productive firms and the tilt was quantitatively significant. There is no strong evidence that the allocation of credit by banks was biased towards less-productive firms before and after the pandemic (the coefficient on the low-TFP indicator is positive but not significant in columns (1)-(2) of Chart B.8, panel a), consistent with banks focusing on the assessment of credit risk, rather than identifying high-productivity firms. However, the opposite holds for the pandemic period. During this period, new loans were higher for less-productive firms – by around 0.3% of total firm assets – than for more-productive competitors (positive and significant coefficient on the low-TFP indicator in column (3)). This effect is confirmed when measuring firm productivity based on levels observed in 2019 (column (4)). In other words, the allocation of credit to low-TFP firms during the pandemic seems to reflect credit allocation to genuinely less-productive firms rather than a cyclical decline in productivity during the period of pandemic shutdowns. Importantly, banks with low non-performing loan levels and which specialise in corporate lending were less likely to lend to low-TFP firms during that period. Higher capital and liquidity ratios also seem to have limited lending to low-TFP firms (significant coefficients on the interaction between the low-TFP indicator and bank variables in column (3)).

Chart B.8

Regressions of loan growth on bank characteristics and the impact of government guarantees

a) Regressions of new term loans on selected firm and bank characteristics

(2019-23, percentage of total assets and significance levels)

	New term loans (percentage of total assets)
Variable	(1)	(2)	(3)	(4)±
Period	2019-23	2019 and 2022-23	2020-21	2020-21
Low-TFP firm	0.113	0.008	0.273***	0.333***
Low-TFP firm interaction with:
CET1 capital (% of RWA)	-0.009	-0.019	-0.056***	-0.058***
NPL ratio (% of loans)	0.026	0.016	0.078***	0.066***
LCR (%)	-0.001	-0.0007	-0.001***	-0.001***
NFC loans (% of bank assets)	0.027	0.053	-0.026***	-0.021***
ROE	0.006	0.023	0.018***	0.019***

b) Impact of government guarantees on new credit to firms during the pandemic

(2020, percentage of total assets)

State guarantees were essential in helping viable firms to overcome temporary liquidity issues during the pandemic, with less-productive firms benefiting relatively more than the rest of firms from the guaranteed credit. Government loan guarantees introduced to encourage new bank lending during the pandemic had a positive effect on credit flows to firms. This was essential to prevent bankruptcy in the case of otherwise healthy firms facing temporary liquidity difficulties during the period of pandemic shutdowns. Yet, while largely directed towards the most affected firms, the guarantees also seem to have encouraged more lending to less-productive firms than to other enterprises. The amount of new loans received by a typical less-productive firm in 2020 increased by 8.5% of total assets if the loan was backed by a government guarantee. By contrast, for otherwise similar but more-productive competitors, the additional new lending backed by state guarantees was only 7.4% (Chart B.8, panel b). These findings are consistent with the past literature on state credit guarantees that indicates a certain degree of moral hazard on the part of banks, who may have less incentive to screen borrowers because the underlying risks are partly borne by the government.^[16]

5 Conclusions

Over the long run, persistently weak productivity can undermine economic growth and the resilience of all sectors in the economy. Financial instability tends to be associated with the acute stress that is visible in high volatility, sharp reversals of sentiment and outright financial distress. However, structural weaknesses are equally relevant, as they gradually erode resilience. Persistently weak productivity is one such weakness and can undermine financial stability over the long run. This special feature analyses the role of access to finance, with a focus on bank lending as one of the factors driving aggregate productivity dynamics. It discusses the implications for financial stability.

Overall, the supply of bank credit has tilted more towards less-productive firms in recent years. The main reason for this is that the real estate sector has received a disproportionate share of bank credit despite its limited contribution to TFP growth. In addition, the allocation of bank loans within sectors tilted towards less-productive firms during the pandemic, while before and since the pandemic bank lending and firm productivity were/have been unrelated.

These findings beg the question as to whether more-productive firms have been to some degree crowded out, to the detriment of economic growth and resilience. This concern is relevant given the bank-centric nature of the euro area’s financial system. While the continued flow of bank lending during the period of pandemic shutdowns prevented fundamentally sound firms from becoming insolvent, this special feature points to potential side effects.^[17] The direct effect on bank asset quality of lending to less-productive companies has likely been mitigated by government guarantees at the expense of higher risks for sovereigns and a stronger bank-sovereign nexus. In addition, the tilt towards less-productive firms could have an indirect effect on productivity if the survival of less-productive firms suppresses the profitability of more-productive competitors, discouraging market entry and investment.

An external funding structure that is more diversified could help boost the productivity of euro area firms, to the benefit of financial stability. Equity investors may be more suited to funding inherently riskier but more-productive projects. They have greater incentives to identify frontier firms, as they reap the full benefits if such firms perform better. Some of them have superior skills when it comes to evaluating early-stage technologies while others are able to intervene directly and improve the operational efficiency of firms. Overall, additional progress towards the capital markets union – as part of a comprehensive policy agenda – could help improve growth potential of the euro area economy and support its resilience to adverse shocks.