In this paper, we investigate the economy-wide effects of the collateral channel by exploiting: (i) a legal reform in Sweden in 2004 that reduced collateral values, and (ii) a dataset that covers all incorporated firms in Sweden over the period 2000-2006. We find that the loss in collateral value reduces both the amount and the maturity of firm debt and leads firms to contract investment, employment, and assets. The legal reform may distort investment and asset allocation decisions, as firms

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... t reduce their holdings of assets with low collaterizable value and firms that hold more liquid assets consequently become less productive and innovative. Our results therefore document the potency of a collateral channel outside of a crisis. JEL Classification: D22, G31, G32 Our results establish the importance of the collateral channel and of financing frictions for the real economy. We note, however, that our paper only provides a partial analysis of the impact of the reform. For instance, the main objective of the law was to avoid inefficient liquidation and allow viable companies to enter reorganization. Our paper is silent about the effects of the law on the fates of companies in financial distress. The results in this paper thus do not necessarily imply that the 2004 law is a welfare destroying reform.