Financial Crises, Debt Financing, and Default Risks

Abstract

We examine the mechanism through which a financial crisis affects the default risk of real economy firms. We find that firms with strong dependence on bank financing suffer from higher increases in default risk than firms with no such dependence. Conversely, firms that rely solely on financing from public debt markets do not experience significant increases in default risk. We also find that the increase in default probabilities, caused by a decrease in bank lending, is only significant for firms with low credit quality. These findings suggest that the bank supply shock theory helps explain the transmission channel of shocks from the financial sector to the real economy. Finally, firms dependent on bank financing cannot completely offset adverse impacts stemming from supply shocks in bank lending by substituting bank loans with publicly traded debt.