Asset Specificity, Industry Driven Recovery Risk and Loan Pricing

Abstract

We provide evidence that a firm’s exposure to industry downturns, what we refer to as industry risk, is an important factor affecting ex post recovery rates and ex ante bank loan pricing and the borrowing firms use of cash. The basic idea is that if it is costly to redeploy industry assets, then the liquidity of a firm’s assets will vary with the industry as well as macro-economic conditions. Since the cost of bank financing depends in part on the bank’s assessment of loss given default (LGD), firm’s with greater exposure to industry downturns (and hence higher expected LGD) will find bank loans as a more expensive and conditional source of liquidity. While industry risk exposure is closely related to firm’s aggregate risk exposure, we provide evidence of an independent effect of industry risk on recovery rates and loan pricing. We measure industry risk in several ways. The first is the covariance of the firm’s stock returns with the return of its industry peers controlling for aggregate (or market) risk. The other measures are tail risk measures, based on the relations between a firm’s stock returns and industry returns conditional on an industry downturn. We find that industry risk is significantly related to the likelihood of the firm being in financial distress when its peers are also in distress and recovery rates in bankruptcy. More importantly, we find that the spreads on unsecured bank loans are significantly related to our tail risk measures. Moreover, we find that the likelihood of secured borrowing is positively related to industry risk exposure. We find that these relationships are stronger for firms with industry specific assets. We also find that cash reserves and the reliance on cash relative to lines of credit are significantly related to our measures of industry risk exposure. Overall our results suggest that the liquidity of a firm’s operating assets together with the firms aggregate risk exposure affects recovery rates, loan pricing and reliance on cash as a source of liquidity.

Keywords: credit risk, loan pricing, asset specificity, financial distress, liquidity management

JEL Classification: G32, G33