Firm Credit Risk Research Articles

Dissecting E, S, and G for risk mitigation: insights from the term structure of CDS

ABSTRACT In this study, we utilize a comprehensive dataset of US-traded credit default swaps (CDS) to assess the impact of environmental, social, and governance (ESG) adoption on firm credit risk. Our study examines corporate bonds with key maturities from 0.5 to 30 years, covering data from 2007 to 2022. We apply fixed effects regression to analyse the impact of ESG scores on CDS spreads. The results are validated through a battery of robustness checks primarily the 2SLS method. The study finds that ESG scores, including the individual pillars, play a significant role in mitigating credit risk. The intriguing aspect of the finding is the decline in risk mitigation as the term-to-maturity increases. Further, the social pillar causes the highest sensitivity to credit risk, followed by the environmental and governance pillars. The effect of ESG adoption is slightly greater for subordinated bonds compared to senior tranches, however, the effects diverge for individual pillars. The study offers practical insights as understanding the relationship between sustainable practices and CDS term structure helps refine investment strategies and specifically pricing of credit risk.

Effects of climate change on firm credit risk: evidence from China

ABSTRACT Our study examines the impact of extreme weather on corporate credit risk, identifies the impact pathway, and explores the influences of different heterogeneity contexts. We propose a modified version of the climate risk measure, Modified Regional Wise Climate Risk Index for Company (MRW-CRIc), which considers not only the climate risk on financial loss but also company-specific factors. We find that climate risk significantly affects enterprise credit risk and that the impact of extreme weather varies across three industries. This research contributes to regulatory efforts by enhancing the measurement of climate risk and deepening understanding of its implications for market stability.

Is climate transition risk priced into corporate credit risk? Evidence from credit default swaps

We study whether climate transition risk is reflected in the credit default swap (CDS) spreads of European firms. Using information on the vulnerability of a firm’s value to the transition to a low-carbon economy, we construct a climate transition risk (CTR) factor, and report how this factor shifts the term structure of the CDS spreads of more but not of less vulnerable firms. Considering the CTR factor, we find that different climate transition policies have asymmetric and significant economic impacts on the credit risk of more vulnerable firms, and negligible effects on less vulnerable firms.

Fintech development and corporate credit risk: Evidence from an emerging market

This paper analyzes the impact of fintech development on the credit risk of non-financial firms. Using the city-level fintech development index constructed based on data from Ant Finance Service Group, we find that: (1) non-financial firms in cities with better fintech services have lower credit risk; (2) two channels identified are financial constraints and corporate investment efficiency; (3) the role of fintech development in reducing corporate credit risk are more pronounced for non-state-owned firms, small and medium-sized firms, firms in regions with a lower level of marketization, and firms experiencing economic contraction. Our research provides implications for the development of fintech in an emerging market.

The impact of environmental information disclosure on the cost of debt: evidence from China

ABSTRACT With the growing attention being paid to environmental issues by the public, environmental information disclosure (EID) has become a vital means for firms to convey their social responsibility and an important information source for lending institutions to assess firm credit risk. Based on the data of listed companies in China, a two-way fixed effects model is applied in this study to determine the impact of EID on the cost of debt. It reveals that EID can decrease companies’ cost of debt and that both CEO duality and ownership concentration play vital roles in this relationship. After the consideration of endogeneity problems and robustness testing, the conclusions remain valid.

Gender diversity in leadership: Empirical evidence on firm credit risk

We study the relation between firm financial stability and gender diversity in leadership and highlight its dependence on the initial financial conditions of the firm and the role played by the women leaders. Consistent with the glass cliff and the upper echelon theories, we find that close-to-default firms are more likely to appoint women top executives and that under their leadership, subsequent firms’ risk of default decreases in the short to medium term. In parallel, independent women directors are not associated with firms’ past credit risk, and their presence is more likely to increase the firm’s subsequent default risk, as established by the tokenism and signaling theory. Our results are robust to alternative specifications and endogeneity corrections.

Alternative data and trade credit financing: Evidence from third-party online sales disclosure

This study examines the relationship between the introduction of alternative data and trade credit financing. Using the event of the public launch of firm online sales data in a well-known financial database in China, we show that firms obtain more trade credit from suppliers with the public disclosure of such alternative data. We extend the literature by shedding light on the important role of alternative data in capital markets to assess the operational transparency and credit risk of firms.

Assessment of associated credit risk in the supply chain based on trade credit risk contagion.

Assessment of associated credit risk in the supply chain is a challenge in current credit risk management practices. This paper proposes a new approach for assessing associated credit risk in the supply chain based on graph theory and fuzzy preference theory. First, we classified the credit risk of firms in the supply chain into two types, namely firms' "own credit risk" and "credit risk contagion"; second, we designed a system of indicators for assessing the credit risks of firms in the supply chain and used fuzzy preference relations to obtain the fuzzy comparison judgment matrix of credit risk assessment indicators, on which basis we constructed the basic model for assessing the own credit risk of firms in the supply chain; third, we established a derivative model for assessing credit risk contagion. On this basis, we carried out a comprehensive assessment of the credit risk of firms in the supply chain by combining the two assessment results, revealing the contagion effect of associated credit risk in the supply chain based on trade credit risk contagion (TCRC). The case study shows that the credit risk assessment method proposed in this paper enables banks to accurately identify the credit risk status of firms in the supply chain, which helps curb the accumulation and outbreak of systemic financial risks.

An Analysis of Carbon Pricing-Induced Credit Risk of European Firms

An Analysis of Carbon Pricing-Induced Credit Risk of European Firms

Is controlling shareholders' credit risk contagious to firms? — Evidence from China

This paper investigates the contagion effect through shareholdings and the mechanism through which credit risk spreads from controlling shareholders to firms in the Chinese market. We use data on the judicial freeze of controlling shareholders to measure their credit risk and measure firm credit risk by default probabilities estimated from the KMV model. The empirical results show that a higher credit risk of the controlling shareholder is significantly associated with a higher credit risk of the firm in subsequent quarters. The baseline results are robust to a series of robustness tests and are pronounced when applying different methodologies that address potential endogeneity issues. This paper reveals an expropriation channel through which troubled controlling shareholders interfere with firms' efficient running of the business and thus lead to higher firm credit risk. We also provide empirical evidence that lower trust in firms, which shows up as less trade credit and higher borrowing costs, is another possible mechanism through which credit risk spreads from the controlling shareholder to the firm. Finally, we find that the credit risk contagion effect from the controlling shareholder is more pronounced among firms without independent CEOs and non-state-owned enterprises.

The mitigation role of corporate sustainability: Evidence from the CDS spread

We investigate the mitigation effect of firms’ ESG, a proxy of sustainability, on the CDS issued by corporations listed on the S&P500. We aim to shed new light on the risk mitigation effect by disentangling the empirical evidence across economic sectors and the ESG determinants. Results provide strong evidence that ESG scores are negatively associated with firm credit risk once controlling for endogeneity. These conclusions are robust after controlling for restructuring clauses, financial crisis period, and different maturities. Under the Basel framework, financial intermediaries could operate with lower regulatory capital with an active risk management strategy based on CDS trading policy.

Pension plans’ funded status volatility and corporate credit risk

We investigate whether and how U.S. pension plans’ funded status volatility affects firm credit risk. We first show that a firm's funded status volatility is positively related to its bond yield spread. We then find that the adoption of SFAS No.158 (2006) requiring the recognition of pension funding status on the statement of financial position renders the pension plan information more value-relevant, thereby increasing the effect of funded status volatility on bond yield spread. Furthermore, the predictions that funded status volatility affects asset value volatility and incomplete accounting information, which in turn affects corporate credit risk, are empirically supported. Our findings reinforce the need for firms to disclose reliable information about funded status volatility—a major pension plan risk—to external investors.

The Credit Risk of Sustainable Firms during the Pandemic

This study investigates how the credit risk of more sustainability-oriented firms changes when national governments intervene in their economies to counterbalance the COVID-19 pandemic. For this reason, we examine how the credit default swap spread changes on a database of all listed firms—for which a credit default swaps (CDS) contract is available—in Europe and the United Kingdom during the whole year of 2020. We find that when national governments intervene in the local economies, the CDS spreads for these firms decrease more than for other firms. Furthermore, the CDS spread changes are more sensitive to those policies aimed at supporting household and business income during the pandemic rather than those policies related to stay-at-home measures and investments in healthcare. Our results corroborate previous theories linking firm sustainability, equity and credit risk.

Be good to be wise: Environmental, Social, and Governance awareness as a potential credit risk mitigation factor

AbstractIntegrating Environmental, Social, and Governance (ESG) factors into credit risk assessment is the new frontier for credit risk management as regulators and investors increasingly require banks to channel loans to “sustainable” borrowers and ultimately foster sustainable growth. Our findings show that higher ESG awareness is strongly associated with better creditworthiness (proxied by the Altman Z‐score). We apply a two‐step methodology to 3331 companies from various industries and geographies in the 2000–2016 period which reveals that high ESG awareness scores are strongly and very significantly associated with a reduction in firm credit risk. We check the robustness by using the Probability of Default as a dependent variable and an instrumental variable constructed with a factor analysis. Our results support the appropriateness of the introduction of ESG awareness parameters in the creditworthiness assessment of borrowers.

Gender Diversity in Leadership: Empirical Evidence on Firm Credit Risk

Gender Diversity in Leadership: Empirical Evidence on Firm Credit Risk

Forecasting credit ratings of decarbonized firms: Comparative assessment of machine learning models

• We assess the ability of machine learning models to predict credit ratings. • For low-carbon firms, classification and regression trees have the best precision. • The random forest ensembles have the second-best accuracy of rating predictions. • In firms with financial distress, artificial neural network models are also suitable. Maintaining low carbon energy transitions is a phenomenon that is critical in curtailing greenhouse emissions. However, such shifts usually warrant incremental capital expenditures, which require an uninterrupted access to financing. Credit ratings are an essential consideration of the financing process. In this paper, we assess the ability of various machine learning models, in order to forecast the credit ratings of eco-friendly firms. For this purpose, we have employed a sample of 355 Eurozone firms that are ranked on the basis of the extent of their climate change score by SDP, between the years spanning from 2010 to 2019. The study uses various machine learning methods, and the findings suggest that classification and regression trees have the most precision for the credit rating predictions. Even when the forecasting was constrained to the investment grades, speculative grades, or default categories, the accuracy remained robust. The results also suggest that a random forest ensemble can be used alongside the regression trees in order to predict default or near default ratings. Given that such firms face dynamic risk exposure towards environmental, ecological, and social factors, these results have important implications that can be taken into consideration when assessing the credit risk of pro-ecological firms.

The Impact of Banking Competition on Firm Credit Risk and Leverage

A firm’s default risk is closely related to its macrofinancial stability. As financial reform deepens, banking competition may ease firms’ credit constraints, encouraging them to increase their leverage and default risks. This study uses contingent claims analysis to examine firms’ asset–liability ratio and default distance. We find that companies have low leverage and low overall default risks. Moreover, a pro-cyclical effect exists between leverage and economic growth. As banking competition becomes more intense, the default risk decreases, but firms’ leverage ratio rises significantly. The impact is more prominent for highly leveraged firms. Our findings also indicate that utilizing the contingent claims analysis method to measure firms’ leverage and default risks provides more accurate results. Moreover, we provide empirical evidence of the impact of banking competition on firms’ leverage and credit risks. The results suggest that enhancing financial competition has a positive effect on easing credit constraints and reducing default risks.

Determining the Credit Score and Credit Rating of Firms using the Combination of KMV-Merton Model and Financial Ratios

Credit risk management has become a must in this era due to the increase in the number of businesses defaulting. Building upon the legacy of Kealhofer, McQuown, and Vasicek (KMV), a mathematical model is introduced based on Merton model called KMV-Merton model to predict the credit risk of firms. The KMV-Merton model is commonly used in previous default studies but is said to be lacking in necessary detail. Hence, this study aims to combine the KMV-Merton model with the financial ratios to determine the firms’ credit scores and ratings. Based on the sample data of four firms, the KMV-Merton model is used to estimate the default probabilities. The data is also used to estimate the firms’ liquidity, solvency, indebtedness, return on asset (ROA), and interest coverage. According to the weightages established in this analysis, scores were assigned based on those estimates to calculate the total credit score. The firms were then given a rating based on their respective credit score. The credit ratings are compared to the real credit ratings rated by Malaysian Rating Corporation Berhad (MARC). According to the comparison, three of the four companies have credit scores that are comparable to MARC’s. Two A-rated firms and one D-rated firm have the same ratings. The other receives a C instead of a B. This shows that the credit scoring technique used can grade the low and the high credit risk firms, but not strictly for a firm with a medium level of credit risk. Although research on credit scoring have been done previously, the combination of KMV-Merton model and financial ratios in one credit scoring model based on the calculated weightages gives new branch to the current studies. In practice, this study aids risk managers, bankers, and investors in making wise decisions through a smooth and persuasive process of monitoring firms’ credit risk.

Why are commercial loan rates so sticky? The effect of private information on loan spreads

Past studies find that commercial loan spreads are “sticky” in the sense that they do not fully respond to changes in open market rates or observable firm credit risk characteristics. In this paper, we provide evidence that the appearance of stickiness arises, in part, because the intensity of bank screening varies inversely with changes in both observable firm credit risk characteristics and credit market conditions. Our analysis demonstrates that stickiness in loan spreads does not necessarily indicate loan mispricing or misallocation of credit.

Dollar borrowing, firm credit risk, and FX-hedged funding opportunities

We explore the link between firms' dollar bond borrowing and their FX-hedged funding opportunities, as reflected in a positive corporate basis (the relative cost of local to synthetic currency borrowing). We first document that firms substitute domestic for dollar borrowing when the corporate basis widens. Additionally, we find that when these funding opportunities appear, the currency substitution is greater for highly rated firms. The willingness of highly rated firms to issue dollar bonds when the basis widens is stronger during periods of heightened demand for dollar-denominated safe assets.