Financial Crises, Financing Sources, and Default Risks

Abstract

As the 2007-2009 episodes clearly illustrate, banking and financial market crises negatively affect real-economy firms, leading to lower stock market valuations, lower investments, reductions in hiring, and a subsequent decrease in aggregate economic activity. However, there is little agreement on the mechanism through which these crises (originated in the financial sector) affect the default risk of real-economy firms. In this paper, we examine the mechanism through which a financial crisis affects the default risk of real economy firms using the natural experiment of the 2007-2009 Global Financial Crisis (GFC). We develop a novel empirical methodology along with a new identification strategy by examining firms’ ex ante reliance on various financing sources and a robust methodology of difference-in-differences matching estimator. Our methodology also controls for many relevant firm risk characteristics. Using an extensive database of listed non-financial firms in the U.S. market during the period of 2006Q3-2010Q1, we find that firms with strong dependence on bank financing suffer higher increases in default risk than similar firms without such dependence. Conversely, firms relying solely on financing from public-debt markets do not experience significant increases in default risk. These findings suggest that the bank supply shock theory helps to understand the transmission channel of shocks from the financial sector to the real economy as far as default risk is concerned. Finally, we examine whether bank-dependent firms can substitute bank loans by issuing publicly traded debts, in order to mitigate the increase in default risks due to bank-lending supply shocks. We find that, in this sample, bank-dependent firms cannot completely offset adverse impacts stemming from bank-lending supply shocks by substituting bank loans with publicly traded debts. Information related to borrowers’ credit quality is a fundamental determinant of debt contracting and credit spreads. Our work provides useful information for policy makers interested in understanding the extent to which impairments in the bank-lending channel contribute to an increase in the probability of bankruptcies, thus deepening recessions. Monetary policy can work through its impact on the bond-market rate of interest or on the supply of intermediated loans. Our key result (firms dependent on bank loans suffer stronger increases in default probabilities than firms dependent on bond markets) suggests that regulators should put high importance on fixing the bank-lending channel in a timely manner when a financial crisis materializes.

Keywords: Bank Supply Shock, Credit Supply Shock, Bank Dependence, Public-Debt Market, Distance-to-Default, Substitution Effect

JEL Classification: G00; G18; G21; G32; G33