Bank default risk propagation along supply chains: Evidence from the U.K.

Abstract

How does banks' default risk affect the probability of default of non-financial businesses? The literature has focused on the banks' direct corporate customers. It fails to consider the role of supply chain relationships as a powerful channel for default risk contagion. Our paper fills this gap by analyzing the direct as well as the indirect impact of banks' default risk on firms' default risk in the U.K. Relying on Input-Output tables, we devise methods that enable us to examine this question in the absence of data on firm-to-firm linkages. To capture all potential propagation channels, we account for horizontal and vertical linkages, both between the firm and upstream industries (suppliers) and between the firm and downstream industries (customers). We further examine how trade credit and contract specificity amplify or dampen the propagation of default risk. Our results show that increases in banks’ default risk from the banking crisis of 2007–2008 propagated strongly to U.K. non-financial firms via supply chains.