The Role of Leverage in Firm Solvency: Evidence From Bank Loans

Abstract

The two recessions that hit Italy since the end of 2008 have raised substantially the share of non-performing loans to businesses in banks’ portfolios. In this paper we evaluate to what extent the deterioration of credit quality resulted not only from the drop in firms’ sales during the contraction of economic activity, but also from the level of firms financial debt at the onset of the first recession. Our results show that, ceteris paribus, a 10 % points increase in leverage is associated with almost a 1 % point higher probability of default. Moreover, the adverse impact of a drop in sales on firm solvency is almost four times larger for firms in the highest quartile of the leverage distribution than for firms in the first quartile. These findings confirm that the firms’ financial structure can be a powerful amplifier of macroeconomic shocks. A higher level of borrowers’ leverage reduces their resilience during a recession, and this in turn weakens the balance-sheets of banks and their ability to provide credit.