Firm Default Research Articles

Corporate social responsibility and default risk: International evidence

Using a large sample of firms from 36 countries between 2002 and 2016, this study investigates the relationship between corporate social responsibility (CSR) and default risk, with a focus on the differential effect conditional on the lengths of time horizons. We find that CSR is negatively associated with probability of default and the effect is stronger in the long term than in the short run. Further, the impact of CSR on firm default probability appears to be greater in countries with weaker capital markets and legal institutions. Overall, our findings provide evidence supporting the role of CSR in filling institutional voids.

African firm default risk and CSR

As far we know this study is the first to examine the causal relationship between African firm default risk and CSR and its separate dimensions (environmental, social, and governance dimensions). Bivariate PVAR estimations results show that there is a unidirectional relationship between firm default risk and CSR as well as the environment dimension. Indeed, we note a positive and significant impact of firm stability toward CSR. Besides, our results reveal that environmental performance has a negative and significant impact on firm stability. Finally, our findings conclude that there is a virtuous circle between the governance dimension and firms' stability.

Corporate social responsibility and firm default risk in the Eurozone: a market-based approach

PurposeThe purpose of this study is to examine the relationship between corporate social responsibility (CSR) and the default risk level of firms operating in the Eurozone and how CSR can provide insurance-like protection during financial/economic downturns.Design/methodology/approachBased on prior empirical studies and by integrating the insights of different theories, this study proposes a framework linking CSR, firm default risk and corporate financial performance to explain firms' social behavior that can trigger default risk determinants (e.g. cost of capital, leverage, sales level) directly or indirectly. The authors use a panel regression approach.FindingsThe results support the mitigating effect of CSR on firm default risk. This effect is higher during a financial crisis, suggesting that CSR could provide insurance-like protection during economic downturns. These results hold even after using an alternative risk measure. Granger causality test results strongly suggest that reverse causality is not a concern. An instrumental variable approach is proposed to deal with potential endogeneity issues.Originality/valueWhile other studies examine the CSR–firm default risk relationship in US samples, this study focuses on the Eurozone. The novelty of this work is based on its sample and how financial crises are addressed within this relationship. Insurance-like protection concerns both negative announcements and periods (e.g. financial crises, recessions). The study's results are useful for investors and risk managers who intend to manage default risk in their portfolios or firms.

Debt Financing and Risk Management

We document the importance of loan covenants to observed hedging outcomes, by studying lending agreements and derivative positions of U.S. oil and gas producers. The emergence of fracking technology was accompanied by sharp increases in capital spending and borrowing. The contracts involved often include covenants specifying hedging policies, and more frequently for firms with higher expected costs of default. Firms with contractual hedging commitments have lower borrowing costs and perform better during the COVID-19 pandemic, even after controlling for hedging levels. The results imply that understanding firm’s hedging outcomes requires consideration of binding lending covenants employed to mitigate agency conflicts.

Clear(ed) decision: The effect of central clearing on firms’ financing decision

Does derivative market regulation affect real economic outcomes? We investigate this question in the setting of the central counterparty (CCP) clearing reform on the corporate credit default swap (CDS) market. Exploiting the staggered introduction of CCP clearing to CDS contracts -- an insurance against firm default -- we uncover adverse real economic consequences for affected (non-financial) firms. Firms whose CDS contract is eligible for clearing with the monopolist CCP lose debt funding, shrink their balance sheet, cut employment and become less profitable. We theoretically motivate two channels through which the market environment of derivatives can affect firms’ debt funding situation: the hedging channel, working through increased absolute prices of cleared compared to non-cleared CDS contracts making hedging more expensive; and the arbitrage channel, working through increased relative prices of cleared CDS contracts compared to the associated corporate bonds making the bond market less attractive. We find suggestive empirical evidence for both channels being active in reducing demand for affected firms' corporate bonds.

The Core, the Periphery, and the Disaster: Corporate-Sovereign Nexus in Covid Times

We show that the COVID-19 pandemic triggered a surge in the elasticity of non-financial corporate to sovereign credit default swaps in core EU countries, characterized by strong fiscal capacity. For peripheral countries with lower budgetary slackness, the pandemic had essentially no impact on such elasticity. This evidence is consistent with the disaster-induced repricing of government support, which we model through a rare-disaster asset pricing framework with bailout guarantees and defaultable public debt. The model implies that risk-adjusted guarantees in the core were 2.6 times those in the periphery, suggesting that fiscal capacity buffers provide relief to firms’ financing costs.

COVID-19 and the Credit Cycle: 2020 Revisited and 2021 Outlook

This study continues the author’s examination and forecasts as to the impact of Covid-19 on the U.S. credit cycle after one and a half years since the pandemic first began. We explore the enormous build-up of global debt even before the pandemic commenced and the subsequent record debt expansion through mid-2021. New debt peaks, especially for non-financial corporate debt, is analyzed as to its potential impact on future default rates and the implications for the U.S. credit markets once again starting a new benign cycle in a continuing low interest rate environment. We ask the question whether the spectacular success of the U.S. central bank and its monetary policy and secondary market purchases has also promoted potentially destructive unforeseen consequences for debt rated BBB and below. Large versus small firm defaults and bankruptcies are examined in both 2020 and 2021, as well as our expectations about these firms’ solvency status once the government and central bank supports diminish and are eliminated. Finally, we introduce the concept of global zombie firms and suggest that this growing phenomenon be analyzed more robustly and critically with new criteria and empirical analysis.

Lack of successors, firm default, and the performance of small businesses

We investigate the effects of the lack of successors on small businesses with an elderly manager. Using firm-level data from Japan, a country with an aging population, we find the following results. First, smaller, younger, highly leveraged, and nongrowing firms are likely to have no successor. Second, firms with an elderly manager are more likely to exit and default if they have no successors, and this is particularly the case during the global financial crisis around 2009. This result suggests that these firms have less incentive to repay debts because they are not going concerns. As a result of the high probability of default, the annual change in bank borrowing is low if firms with an elderly manager have no successor. Third, the annual change of bank borrowing is lower for firms with no successor during the crisis and post-crisis periods, implying that banks reduce lending to these firms because of their high risk.

Corporate-Sovereign Debt Nexus and Externalities

I show that corporate debt accumulation during booms can explain increases in sovereign risk during stress periods. Using idiosyncratic shocks to large firms as instruments for aggregate corporate leverage, I show that rising corporate leverage during the period 2002-2007 causally increases sovereign spreads in six Eurozone countries during the debt crisis period of 2008-2012. To explain these findings, I build a dynamic quantitative model in which both firms and the government can default. Rising corporate debt increases sovereign default risk, as tax revenues are expected to decrease. Externalities arise because it can be privately optimal but socially suboptimal for firms to default given their limited liability. The fact that firms do not take into account the effect of their debt accumulation on aggregate sovereign spreads is an important externality, rationalizing macroprudential interventions in corporate debt markets. I propose a set of such optimal debt policies that reduce the number of defaulting firms, increase fiscal space, and boost household consumption during financial crises. Both constant and countercyclical debt tax schedules can correct overborrowing externalities. Contrary to conventional wisdom, countercyclical debt policy is less effective than constant debt policy, as the countercyclical policy induces more firm defaults.

Gender, Credit, and Firm Outcomes

Small and micro enterprises are usually majority owned by entrepreneurs. Using a unique sample of loan applications from such firms, we study the role of owners’ gender in the credit decision of banks and the post-credit decision firm outcomes. We find that, ceteris paribus, female entrepreneurs are more prudent loan applicants, with both the probabilities to apply for credit and of firm default after the loan origination being smaller. However, the relatively more aggressive behavior of male applicants pays off in terms of higher average firm performance after the loan origination.

Capital Gaps, Risk Dynamics, and the Macroeconomy

Motivated by the increasing interest in analyzing the links between the financial sector and the real economy, we develop a macro-financial structural model with two novel features. First, we include idiosyncratic and aggregate risk in a tractable general equilibrium model. This allows us to capture sectoral dynamics and the probabilities of default of both firms and financial intermediaries, and the feedback between them. Second, we introduce the concept of sticky (observed) versus flexible (agents’ target) capital. The identified differences between realized and optimal values — the capital gaps of firms and banks — lead financial and business cycles, and cause gaps in credit spreads and asset prices. The model can be used as a signaling device for macroprudential intervention, and to gauge whether macroprudential action was successful ex-post (e.g., whether gaps were closed). For illustration, we show how the analysis of gaps can be applied to the U.S. economy using Bayesian estimation techniques.

Macroeconomic determinants of credit risk: Evidence from the Eurozone

AbstractWe propose and estimate several models controlling for firm‐specific information, to examine the relation of macroeconomic variables with the probability of default of firms in the Eurozone. The novelty of our approach consists in capturing the informational value of macroeconomic factors on credit default prediction by using data from firms spanning 11 European countries; our panel data set covers 534 thousand firm‐year observations. The results we obtain confirm that macroeconomic information strengthens the accuracy of models forecasting credit default of non‐financial firms. With a negative effect on the probability of default, GDP growth stands out among the key macroeconomic predictors of default. Yet, we find compelling evidence that asymmetries exist within the Eurozone regarding the benign effects of GDP growth over credit risk; the reduction of the probability of default due to economic growth mostly occurs in economies more exposed to conditions of financial stress.

Internationalization and firm default risk: The roles of environmental dynamism and marketing capability

Internationalization's role on firm performance has captured massive research attention. However, its influence on firms' default risk, an important firm outcome that not only reflects the backward-looking firm managerial effectiveness but also signifies the forward-looking willingness-to-support from key stakeholders such as debt holders, is not found in the literature. This current research is developed to fill this important theoretical gap by formulating a moderating model that simultaneously incorporates internationalization, environmental dynamism, and marketing capability towards their dynamic joint effects on global firms' default vulnerability, and thus it generates more detailed and realistic images of internationalization under the influences of concurrent internal and external contingency factors. Our results show that high marketing capability assists firms that have a high degree of global expansion to reduce default risk. In addition, environmental dynamism can be either a facilitator or hindrance for internationalization's risk reduction, depending on firm capability levels.

Board co-option and default risk

We find that co-opted boards facilitate more erratic and arbitrary decision-making, contributing towards default risk. A one standard deviation increase in co-option increases default risk by 11% relative to normal levels. Supporting the notion that co-option makes decision-making more erratic, we find that stock return volatility and fundamental volatility are higher among co-opted boards and that strategic conformity among such firms is lower. We find no evidence that our results may be driven by firm risk-taking, however, we do find evidence suggesting that co-opted boards are less engaged and involved in strategic decision-making. We also find that external oversight mechanisms, in the form of institutional investors, financial analysts, media coverage, and takeover susceptibility, mitigate the documented effect. Overall, our study documents new evidence on the adverse effect of co-opted boards on firm default probability.

Determinants of corporate default risk in China: The role of financial constraints

Corporate default risk can affect financial stability and the macroeconomy. However, the determinants of corporate default risk in China are not well defined in the literature. We address this issue by using a rich credit event dataset of 981 Chinese listed firms over the period 1998–2013 and study the factors that affect default risk. We demonstrate that leverage, liquidity, firm size are the key firm-specific factors in determining default risk in China, along with macroeconomic factors like interest rate and stock return. Moreover, ‘Too big to fail’ only applies to non-SOEs, as default risk of SOEs is not affected by the firm size. We further find that high liquidity fails to reduce firms default risk, because small-sized firms which are financially constrained have limited cash to prevent financial distress, whereas large firms with greater cash holdings are able to mitigate their default risk as they are unconstrained.

Credit rating migration risk and interconnectedness in a corporate lending network

This study assesses the credit rating migration risk and interconnectedness in Japan's corporate lending market during the fiscal years 2008–2015. First, the study conducts a portfolio credit risk analysis by using outstanding lending data with borrowers’ and lenders’ names. The results show an expected shortfall with tail dependence of t-copula captures the heavy-tailed risk of Japanese institutions. The study also measures credit risk exposures and credit risk amounts by industry sector, and evaluates sector concentration risk. Subsequently, the study analyzes the network structure of lending contracts using network centrality measures. From the perspective of the network, institutions play a central role in terms of degree centrality. Further, the study undertakes a stress test using a historical economic scenario pertaining to a credit rating migration matrix shortly after the Lehman Brothers’ bankruptcy. The test finds a much sparser network structure due to a large number of firm defaults. The study's analysis offers banks and insurers important implications regarding credit risk management of corporate lending.

Corruption as Collateral

We propose corruption can substitute for conventional collateral in enforcing financial commitments when institutions are poor. A theoretical framework with agency frictions is built, in which corruptive relations with government officials keep firms committed to loan payments. Based on this framework, we hypothesize the anti-corruption investigation destroys the commitment mechanism so that firms default and, most importantly, firms default strategically as long as they can substitute corruption with other collateral. We investigate regional data and firm-level data from China, and find powerful evidence supporting our hypotheses.

Identifying Empty Creditors with a Shock and Micro-Data

Firms with credit-default swaps (CDS) traded on their debt may face as hedged creditors have less incentive to participate in firm restructuring. We test for the existence of empty creditors by employing an exogenous change to the bankruptcy code in Germany that effectively removes their potential impact on CDS firms. Using a unique dataset on bank-firm CDS net notional and credit exposures we find that the probability of default for CDS firms drops when the effect of empty creditors is removed. The intensity of this empty creditor effect varies with firm, bank-firm, and creditor hedging characteristics.

Empirical Credit Spread Components of Banks and their Coverage in Structural Models – An Integrated Analysis

During the global financial crisis and euro crisis, credit spreads of European banks have increased sharply, which has not only been attributed to default risk. Credit spreads can be estimated empirically or using structural models. In the KMV model, a firm defaults if the market value of assets falls below the Default Point (DP) based on liabilities. The Distance-to-Default (DD) measures how many standard deviations the asset value is away from DP. Based on DD, Moody's Analytics calculates a physical probability of default, the Expected Default Frequency (EDF). The paper analyzes the relation between the KMV structural model and empirical credit spread components. In addition to default risk, empirical credit default swap (CDS) spreads compensate risk-averse investors for liquidity risk and common spread risk. Default risk can generally be divided into a diffusion and jump component. Fundamental structural models cover default by a continuous decrease in the asset value below the default barrier, while unexpected jumps or (liquidity) shocks – such as bank runs – are not captured. Comparing model-based bank EDFs and empirical CDS-implied default probabilities, with a special focus on financial market and liquidity crises, the residual risks are derived. In contrast, previous studies primarily consider non-financial firms and phases of low financial market volatility. The present empirical study is the first integrated analysis of the determinants of one-year CDS spreads and the EDF of European banks from 2004 to mid-2015. Using a panel regression with time fixed effects, the residual impact on the logarithmized CDS-implied default probability, that cannot be explained by the logarithmized EDF, is decomposed into a systematic and idiosyncratic component. Since the global financial crisis and especially during the euro crisis, the EDF structural model assesses the default probabilities of European banks to be lower than the CDS market does – due to market-wide risks. The systematic residual impact increases substantially at the outbreak of both financial market and liquidity crises. At the onset of the global financial crisis and euro crisis, in particular market-wide liquidity risks imply a stronger increase in CDS spreads compared to EDFs. Combining market-based signals from European bank CDS spreads with model-based signals in an integrated analysis, the risk of a financial market crisis is derived. Market-wide indicators of funding and liquidity risk provide a statistically significant and economically important explanatory power for the systematic residual impact. Moreover, the risk premium is an essential determinant. Compared to alternative crisis indicators, the systematic residual impact achieves an equally good and during the euro crisis even better performance.

Foreign monetary policy and firms' default risk

ABSTRACTThis study documents the relationship between foreign monetary policy and firms' ex-ante forward-looking default probability measures. We analyze market-based measures of default for large non-financial firms in the US and the EMU area. We propose two transmission mechanisms of foreign policy shocks: the foreign demand channel and the foreign debt channel. We show that foreign monetary policy influences firms' default probability largely through the foreign demand channel. We find that the foreign debt channel only played a role for European firms during the early 2000s due to the higher exposure to USD denominated obligations. These results highlight the need for macro-prudential authorities to pay more attention to the foreign demand channel in the struggle against large default events, as the results show that the foreign debt channel is less relevant.