Risk-shifting: Evidence from the 2007 credit crisis

Abstract

I find empirical evidence that financially distressed firms increase investment risk. I exploit a natural experiment where the treated firms must refinance long-term debt during the 2007–2008 credit crisis. When focusing on firms where the incentive to risk-shift is theoretically greater, such as financially vulnerable firms and those with better governance, I find the increase in investment risk is most prevalent among firms that are the most financially vulnerable and when executives benefit from increased risk. Contrary to previous empirical papers that did not find causal evidence of risk-shifting, these results suggest that the risk-shifting does occur when firms are financially distressed.