Low Credit Quality Research Articles

Product market shock, stakeholder relationships, and trade credit

The COVID-19 pandemic resulted in an extremely rare instance of a shock to global product markets. Using quarterly data for a sample of 7397 firms from 54 countries over the period 2017–2020, we study the causal impact of this shock on trade credit. Employing a difference-in-difference analysis, we find that, in contrast to findings in the literature on financial market shocks, low-credit quality firms are credit-rationed by their suppliers during a shock to product markets and that for low-credit quality firms, there is no substitution of trade credit with financial credit. Importantly, however, our analysis shows that low-credit quality firms with better stakeholder relations are able to obtain more trade credit than those with weaker stakeholder relations. Our results are robust to alternative definitions of key variables, alternative methodologies that address endogeneity concerns, a placebo test, stage of market development, and various levels of controls for unobserved heterogeneity. We show that trade credit is conditional on product market conditions and is not always a generous substitute for financial credit. However, maintaining good relations with stakeholders serves as an antidote to the adverse effect of product market shocks on trade credit.

The Role of Capital Expenditure Forecasts in Debt Contracting

This study examines whether the issuance of capital expenditure forecasts facilitates debt contracting by acting as a commitment to not engage in the expropriation of lenders through opportunistic investment activities. We find that firms with higher leverage and lower credit quality are more likely to issue capital expenditure forecasts. Furthermore, for firms that issue capital expenditure forecasts, loan spreads are lower and investment efficiency is greater, and these associations are stronger when the forecasts are more credible. We do not find similar results for earnings forecasts. When comparing the roles of capital expenditure covenant (which typically specify the upper limit of the allowed amount) with capital expenditure forecast, we find that the former reduces overinvestments and the latter reduces underinvestments. These results suggest that capital expenditure forecasts can be a commitment mechanism to reduce contracting costs with creditors. JEL Classification: G31; M4

Informationally advantaged lenders and the credit derivative market: Evidence from Loan only Credit Default Swap (LCDX)

This paper explores the informational role of the Loan Only Credit Default Index (LCDX) on the pricing of syndicated loans. Despite an extensive body of research on credit indices and loan pricing, limited studies have comprehensively assessed the complex relationship between the LCDX and individual loan spreads. Contrary to indices like the CDX, which are largely linked to corporate bonds, the LCDX directly pertains to the syndicated secured loan market, offering valuable insights about the overall credit default market and the cost of credit risk insurance. Preliminary results reveal a pronounced positive correlation between the LCDX spread and the syndicated loan spread, particularly noticeable amongst borrowers with lower credit quality. The paper highlights the LCDX's pivotal role in conveying secondary credit market information, with critical implications for credit risk management and financial regulations.

Macroeconomic impact and stock returns' vulnerability by size, solvency, and financial distress

We examine how firms' equity value, financing and credit quality respond to changing macroeconomic indicators. We provide evidence that the value of small, low-credit quality, and financially distressed companies are more vulnerable to labor market changes. Our findings show that the equity value of U.S. companies deteriorates when the economy experiences increased cost of capital from an inflation hike, a decrease in domestic output, and uncertainty in the labor market. Our findings are robust to changes in the sample period and after controlling for disparities across industries, states, and firms.

How do industry tournament incentives affect firm debt maturity?

Our study investigates the effect of external industry tournament incentives on debt maturity structure. Prior research shows that industry tournament incentives motivate managers to employ more risky strategies. Recognizing this stronger tendency for risk-taking, creditors may shorten debt maturity and subject managers to more frequent scrutiny by debt markets. Consistent with this notion, our results show that stronger industry tournament incentives lead to significantly more short-term debt. This effect is more pronounced in firms with low credit quality, in areas with a high density of firms from the same industry, and in industries with more CEO positions.

When banks become shareholder activists

This study investigates the relationships between bank activism and target firms’ debtholder value, shareholder value, and firm performance. We find that bank activists are more likely to target firms with heavier syndicated loan borrowing and lower credit quality than other shareholder activists. Bank activism events are associated with significantly positive abnormal bond returns, and this effect only exists in the subset of observations where bank shareholder activists possess a loan stake in the target firm. The target firms of bank activism exhibit a significant improvement in credit quality, coupled with decreases in syndicated loan interest rate spreads, crash risk, and CEO risk-taking incentives.

Do banks fuel climate change?

Do climate-oriented regulatory policies affect the flow of credit towards polluting firms? We match loan-level data to firm-level greenhouse gas emissions to assess the impact of the Paris Agreement. We find that, following this agreement, European banks reallocated credit away from polluting firms in relative terms. Specifically, euro area banks’ loan share to more polluting firms decreased by about 3percentage points compared to less polluting (or “green”) firms after the 2015 Paris Agreement (COP21). This result is stronger for banks that are well capitalized, have lower credit quality, and are less profitable.

Aging and public financing costs: Evidence from U.S. municipal bond markets

We examine the impact of population aging on municipal access to credit. A one standard deviation increase in a state’s population age leads to a 23 basis point increase in municipal bond issue spread. Three mechanisms drive this effect: income tax revenue, healthcare spending, and pension liabilities. Constitutional pension protections and securities with lower credit quality or longer maturity exacerbate the effect. To control for endogenous migration and mortality patterns, we exploit variation from historical state fertility trends. Our findings highlight the challenges municipalities face to cope with systemic demographic transition.

CREDIT QUALITY AND SUBSTITUTION IN SME FINANCE

We investigate whether and how SMEs’ credit quality influences their substitution of bank credit for trade credit. Using data from the five largest European countries, we find that substitution of bank credit for trade credit decreases during the financial crisis, but it decreases significantly less for ex ante low credit quality firms. We control for pre-crisis or lagged firm characteristics including size and external finance dependence, industry effects, sample selection effects and cross-country heterogeneity. We also find that low credit quality firms increase their absolute and relative trade credit usage significantly more than high credit quality firms during the financial crisis. The effects are consistent across countries and stronger for net trade credit borrowers and financially constrained firms. The evidence highlights how credit quality influences demand-side driven substitution in SME finance.

Regulator supervisory power and bank loan contracting

Abstract Using a sample from 38 economies, we examine the relation between bank regulators’ supervisory power and loan spreads. We find that loans issued by banks in economies with more powerful supervisors have higher spreads. The positive association is more pronounced when firms have lower credit quality, when the relationships between firms and banks are less established, when syndicate loans involve fewer lenders, and when lead banks have a riskier profile. Further analyses reveal that loans issued by banks that operate under more powerful supervisors have smaller size and shorter maturity, and the loans are more likely to have collateral requirements and restrictive covenants. Overall, these results suggest that stronger supervisory power of bank regulators affects loan contracting by mitigating lenders’ excessive risk taking.

Regulator Supervisory Power and Bank Loan Contracting

Using a sample from 38 economies, we examine the relation between bank regulators’ supervisory power and loan spreads. We find that loans issued by banks in economies with more powerful supervisors have higher spreads. The positive association is more pronounced when firms have lower credit quality, when the relationships between firms and banks are less established, when syndicate loans involve fewer lenders, and when lead banks have a riskier profile. Further analyses reveal that loans issued by banks that operate under more powerful supervisors have smaller size and shorter maturity, and the loans are more likely to have collateral requirements and restrictive covenants. Overall, these results suggest that stronger supervisory power of bank regulators affects loan contracting by mitigating lenders’ excessive risk taking.

The Optimality of Call Provision Terms

There is substantial variation in fixed-price call provision terms—call price premium and call protection. I investigate determinants of call price, call protection, and estimated call option value. Consistent with agency theory and asymmetric information models, I find that lower credit quality and opaque issuers choose higher call premiums, longer call protection, and overall less valuable call options. Higher-quality issuers, particularly financial institutions that struggle when interest rates are low, do the opposite. This paper was accepted by David Simchi-Levi, finance.

Borrower Selection into Credit Markets: Evidence from Peer-to-Peer Lending

We exploit a quasi-natural experiment in the peer-to-peer lending market to show that the mechanism determining interest rates, irrespective of their levels, influences households' decisions to participate in credit markets. A large online platform unexpectedly switched from auction pricing of loans to centralized price assignment by credit grade. After the change all borrowers in a given credit grade were assigned the same interest rate, potentially exacerbating asymmetric information between borrowers and lenders. Surprisingly, we find that the creditworthiness of borrowers listing on the platform improves. This effect is mainly driven by lower quality borrowers leaving the platform, and is most pronounced for households looking to consolidate existing debt. As a result, less credit is allocated to lower credit quality borrowers. Our findings suggest that the manner in which interest rates are set is an important determinant of households' financing decisions and of selection into credit markets.

Liquidity supply by broker-dealers and real activity

This paper develops a novel measure of liquidity supply by broker-dealers using data on their trading positions in Treasury bonds and the deviations of Treasury yields from a fitted yield curve. The measure is informative about liquidity in other asset classes, including corporate bonds and equities. A decline in liquidity supply predicts reduced debt issuance and investment by nonfinancial firms and reduced aggregate economic activity. The sensitivity of liquidity, issuance, and investment to broker-dealers’ liquidity supply is larger for firms with low credit quality. The results suggest that securities intermediaries are important for understanding liquidity commonality, corporate financing, and real activity.

Pledgee competition, strategic disclosure, and future crash risk

We investigate whether pledgee competition affects the disclosure choice of firms whose controlling shareholders pledge their shares. We find that pledgee competition is positively related to pledge firms’ annual report tone management. This positive relationship is stronger for pledge firms with lower credit quality and non-state-owned enterprise pledge firms. Further corroborating our results, higher pledgee competition increases the future crash risk of pledge firms. Collectively, our results suggest that competition pressure induces pledgees to lower their monitoring incentives to remain competitive in the marketplace, thus leading to pledge firms’ bad news hoarding behavior.

Liquidity Supply and Real Activity

This paper develops a novel measure of liquidity supply by broker-dealers using data on their trading positions in Treasury bonds and the deviations of Treasury yields from a fitted yield curve. The measure is informative about liquidity in other asset classes including corporate bonds and equities. A decline in liquidity supply predicts reduced debt issuance and investment by non-financial firms and reduced aggregate economic activity. The sensitivity of liquidity, issuance, and investment to broker-dealers' liquidity supply is larger for firms with low credit quality. The results suggest that securities intermediaries are important for understanding liquidity commonality, corporate financing, and real activity.

Aging and Public Financing Costs: Evidence from U.S. Municipal Bond Markets

We examine the impact of population aging on municipal access to credit. A one standard deviation increase in a state’s population age leads to a 23 basis point increase in municipal bond issue spread. Three mechanisms drive this effect: income tax revenue, healthcare liabilities, and pension underfunding. Constitutional pension protections and securities with lower credit quality or longer maturity exacerbate the effect. To control for endogenous migration and mortality patterns, we exploit variation from historical state fertility trends. Our findings highlight the challenges municipalities face to cope with systemic demographic transition.

Fintech Isn’t So Different From Traditional Banking: Trading Off Aggregation of Soft Information for Transaction Processing Efficiency

We examine trade-offs that Prosper, a large online peer-to-peer lending platform, has made over time in its lending processes. Since its 2006 inception, Prosper has (1) changed the way it sets the interest rates on loans from auctions among peer lenders to pre-set pricing based on a proprietary credit-rating model in December 2010; (2) enabled institutional investors to fund whole rather than just fractional loans in April 2013; and (3) reduced the extent of soft information available to peer lenders in September 2013. In each of these changes, Prosper has traded off the aggregation of soft information by peer lenders for transaction processing efficiency, a trade-off similar to that made by large traditional banks. We provide the following evidence regarding the costs and benefits of this trade-off. On the cost side, after the December 2010 change the distribution of loan interest rates shrinks and the ability of interest rates to predict loan default deteriorates, particularly for loans to low credit quality borrowers for whom soft information is more important for credit screening. After the April 2013 change interest rates for low credit quality loans in the fractional loan market are more predictive of default than are interest rates in the whole loan market. On the benefit side, loan volume and funding speed rise sharply after each of these changes. Moreover, the costs appear manageable, as peer lenders’ ability to diversify increases and the weighted-average interest rate of a modest-size portfolio of Prosper loans remain just as predictive of default. Placebo and difference-in-differences tests using a peer-to-peer lender that did not change its lending processes during our sample period (Lending Club) indicates that these effects are attributable to the changes in Prosper’s processes.

The domino effect of credit defaults: test of asymmetric default correlations using realised default data

ABSTRACTUsing the research framework of a domino effect in firms, we first make theoretical contributions by addressing several testable hypotheses regarding asymmetrical default correlations. We then employ Lucas’s method to provide empirical evidence based on realised historical default data in the United States from 1992 to 2013. Our empirical results are consistent with the following notions. First, default correlations increase with the time horizon. Second, firms with low credit quality, small size, illiquidity, and a high beta exhibit higher default correlations. Credit risk management without considering asymmetrical default correlations could underestimate portfolio risk due to default clustering.

Balance Sheet Conservatism and Debt Contracting

AbstractWe study the role of borrowers’ balance sheet conservatism (i.e., conservatism in asset values) in debt contract design. We find that borrowing costs are decreasing in the degree of balance sheet conservatism, and this effect is stronger for firms with lower credit quality. This is consistent with balance sheet conservatism reducing lenders’ uncertainty about the liquidation value of assets, thus facilitating the ex ante screening of borrowers. We predict that better ex ante screening also reduces the need for ex post monitoring, and find that balance sheet conservatism is associated with less restrictive covenant terms. Further, we find that asymmetric timeliness in earnings is associated with lower borrowing costs only when balance sheet conservatism is not high. This result suggests that lenders appear to recognize the constraining effect of high balance sheet conservatism on future conservatism in earnings.