The Interaction Effect in a Nonlinear Specification of Bank Lending: A Reexamination of ``Unnatural Selection"

Peek and Rosengren (2005) suggested the mechanism of ``unnatural selection,'' where Japanese banks with impaired capital increase credit to low-quality firms because of their motivation to pursue balance sheet cosmetics. In this study, we reexamine this mechanism in terms of the interaction effect in a nonlinear specification of bank lending, using data from 1994 to 1999. We rigorously demonstrate that their estimation results imply that Japanese banks allocated lending from viable firms to unviable ones regardless of the degree of bank capitalization.