Corporate credit risk modeling and the macroeconomy

Despite a surge in the research efforts put into modeling credit and default risk during the past decade, few studies have incorporated the impact that macroeconomic conditions have on business defaults. In this paper, we estimate a duration model to explain the survival time to default for borrowers in the business loan portfolio of a major Swedish bank over the period 1994–2000. The model takes both firm-specific characteristics, such as accounting ratios and payment behaviour, loan-related information, and the prevailing macroeconomic conditions into account. The output gap, the yield curve and consumers’ expectations of future economic development have significant explanatory power for the default risk of firms. We also compare our model with a frequently used model of firm default risk that conditions only on firm-specific information. The comparison shows that while the latter model can make a reasonably accurate ranking of firms’ according to default risk, our model, by taking macro conditions into account, is also able to account for the absolute level of risk.     

Executive stock options,differential risk-taking incentives,and firm value

The sensitivity of stock options' payoff to return volatility, or vega, provides risk-averse CEOs with an incentive to increase their firms' risk more by increasing systematic rather than idiosyncratic risk. This effect manifests because any increase in the firm's systematic risk can be hedged by a CEO who can trade the market portfolio. Consistent with this prediction, we find that vega gives CEOs incentives to increase their firms' total risk by increasing systematic risk but not idiosyncratic risk. Collectively, our results suggest that stock options might not always encourage managers to pursue projects that are primarily characterized by idiosyncratic risk when projects with systematic risk are available as an alternative.     

Business credit information sharing and default risk of private firms

We investigate whether and how business credit information sharing helps to better assess the default risk of private firms. Private firms represent an ideal testing ground because they are smaller, more informationally opaque, riskier, and more dependent on trade credit and bank loans than public firms. Based on a representative panel dataset that comprises private firms from all major industries, we find that business credit information sharing substantially improves the quality of default predictions. The improvement is stronger for older firms and those with limited liability, and depends on the sharing of firms’ payment history and the number of firms covered by the local credit bureau office. The value of soft business credit information is higher the smaller the firms and the lower their distance from the local credit bureau office. Furthermore, in spatial and industry analyses we show that the higher the value of business credit information the lower the realized default rates. Our study highlights the channel through which business credit information sharing adds value and the factors that influence its strength.     

Capital structure,credit risk,and macroeconomic conditions

This paper develops a framework for analyzing the impact of macroeconomic conditions on credit risk and dynamic capital structure choice. We begin by observing that when cash flows depend on current economic conditions, there will be a benefit for firms to adapt their default and financing policies to the position of the economy in the business cycle phase. We then demonstrate that this simple observation has a wide range of empirical implications for corporations. Notably, we show that our model can replicate observed debt levels and the countercyclicality of leverage ratios. We also demonstrate that it can reproduce the observed term structure of credit spreads and generate strictly positive credit spreads for debt contracts with very short maturities. Finally, we characterize the impact of macroeconomic conditions on the pace and size of capital structure changes, and debt capacity.     

Employee well-being,firm leverage,and bankruptcy risk

Employees of liquidating firms are likely to lose income and non-pecuniary benefits of working for the firm, which makes bankruptcy costly for employees. This paper examines whether firms take these costs into account when deciding on the optimal amount of leverage. We find that firms with leading track records in employee well-being significantly reduce the probability of bankruptcy by operating with lower debt ratios. Moreover, we observe that firms with better employee track records have better credit ratings, even when we control for differences in firm leverage.     

Credit crises, money and contractions: An historical view

The relatively infrequent nature of major credit distress events makes an historical approach particularly useful. Using a combination of historical narrative and econometric techniques, we identify major periods of credit distress from 1875 to 2007, examine the extent to which credit distress arises as part of the transmission of monetary policy, and document the subsequent effect on output. Using turning points defined by the Harding-Pagan algorithm, we identify and compare the timing, duration, amplitude and co-movement of cycles in money, credit and output. Regressions show that financial distress events exacerbate business cycle downturns both in the 19th and 20th centuries and that a confluence of such events makes recessions even worse.     

Bank capital, firm liquidity, and project quality

We construct an economy where a two way interaction between bank capital and project quality propagates negative shocks to technology or regulation. By shrinking the available liquidity and the scale of their activity, a contraction in bank loans discourages entrepreneurs from sustaining the set-up effort of high quality projects, inducing them to shift to low quality ones. The deterioration in project quality erodes the value of bank assets and, hence, banks’ capitalization and loanable funds. Lack of information in the secondary market for bank assets amplifies the propagation.     

Dynamic risksharing in the United States and Europe

We use a panel VAR model to improve upon the existing methodologies to analyze interregional risksharing and consumption smoothing channels. First, we endogenize the output process within a more general multi-equation framework, capturing the dynamic feedback between output and various smoothing channels. Second, in line with dynamic general equilibrium open economy models of risksharing, we exploit impulse response functions to trace the role of each smoothing channel over time, in the presence of different structural shocks (temporary vs. permanent and output vs. smoothing channels). In the application to the US and OECD countries, we find different dynamic properties of different smoothing channels. We compare our results with the predictions of standard risksharing and consumption theories, and tackle some of the puzzles in the literature, such as the “international risksharing puzzle” and the “consumption-output correlation puzzle.” We are also able to address such policy issues as whether fiscal stabilizers have been substitutes or complements for financial market diversification activities and whether further financial market integration is likely to provide countries with more shock-absorption tools. A key result is the strong substitutability between capital and credit smoothing in the US, and between fiscal and credit smoothing in the OECD.     

The macroeconomic sources of systemic risk in the banking sectors of five new EU member states

Rapid credit growth has been one of the most pervasive developments in recent years in Central and Eastern Europe. Our estimates support the hypothesis that the growth of credit and the amount of available finance might harm banking performance and deteriorate non-performing loans (NPL) dynamics, most probably due to the overheating of economies in the five NMSs. The procyclicality of banking sector performance and high economic activities growth is a signal of an economy overheating and therefore a slowdown in economic activity is likely to accelerate the growth of the NPL ratio.     

The impact of foreign stock markets on macroeconomic dynamics in open economies: A structural estimation

With the increased international financial integration in recent years, bilateral financial linkages between countries may have a growing influence on their real economies. This paper employs a structural two-country New Keynesian model, which incorporates a cross-border wealth channel, to estimate the effect that foreign stock market fluctuations may have on macroeconomic variables in open economy countries.The model is estimated using Bayesian methods on a sample of open economies that can potentially be affected by changes in a larger foreign stock market: Australia, Canada, New Zealand, Ireland, Austria, and the Netherlands. The estimation allows for deviations from rational expectations and for learning by economic agents.The empirical results indicate important cross-country wealth effects for Ireland and Austria, from fluctuations in the U.S. and U.K. and in the U.S. and German stock markets, respectively; the wealth effect is largest in Ireland. The data favor, instead, specifications with no significant wealth effect for the remaining countries. Foreign stock price fluctuations, however, still play a role by affecting domestic expectations about future output gaps in all countries in the sample.     

Asymmetric information and liquidity constraints: A new test

Using a novel measure of the degree of information asymmetry across firms, this study shows that information-related financial market imperfections do matter for a firm’s access to external finance. Prior studies of the importance of liquidity constraints faced by nonfinancial firms have suffered from a glaring weakness. They have been based on a sample of publicly traded firms, omitting precisely those firms most likely to be liquidity constrained. Furthermore, they have tended to rely on indirect measures of the degree of information asymmetry, such as firm size. We overcome these limitations by focusing on the banking sector. Unlike the nonfinancial sector, the banking sector has balance sheet and income data available for all firms, whether or not they are publicly traded. This allows the use of a superior measure of the degree of information asymmetry across firms by distinguishing between publicly traded and non-publicly traded banks.     

Investment dynamics with fixed capital adjustment cost and capital market imperfections

This paper examines the implications of financing frictions on capital stocks and on capital accumulation in the presence of non-convex costs of adjusting the capital stock. In this setup finance has an influence on both, the level of capital and the timing of investment. Finance and productivity are complements and finance influences investment the strongest when firms wish to significantly adjust capital for fundamental reasons. These theoretical considerations are confronted with UK data. While finance is mostly irrelevant for long-term capital decision, the short-run investment function shows a significant impact of finance, which is also strongest for strong fundamental investment incentives.     

Credit lines as monitored liquidity insurance: Theory and evidence

We propose a theory of credit lines provided by banks to firms as a form of monitored liquidity insurance. Bank monitoring and resulting revocations help control illiquidity-seeking behavior of firms insured by credit lines. The cost of credit lines is thus greater for firms with high liquidity risk, which in turn are likely to use cash instead of credit lines. We test this implication for corporate liquidity management by identifying exogenous shocks to liquidity risk of firms in corporate bond and equity markets. Firms experiencing increases in liquidity risk move out of credit lines and into cash holdings.     

Seeking safety: The relation between CEO inside debt holdings and the riskiness of firm investment and financial policies

CEO inside debt holdings (pension benefits and deferred compensation) are generally unsecured and unfunded liabilities of the firm. Because these characteristics of inside debt expose the CEO to default risk similar to that faced by outside creditors, theory predicts that CEOs with large inside debt holdings will display lower levels of risk-seeking behavior (Jensen and Meckling, 1976). Consistent with the theoretical predictions, we find a negative association between CEO inside debt holdings and the volatility of future firm stock returns, R&D expenditures, and financial leverage, and a positive association between CEO inside debt holdings and the extent of diversification and asset liquidity. Collectively, our results provide empirical evidence suggesting that CEOs with large inside debt holdings prefer investment and financial policies that are less risky.     

Corporate tax,capital structure,and the accessibility of bank loans: Evidence from China

In this paper, we investigate whether listed firms in China adjust their capital structure in response to an increase in the corporate tax rate. Although theories of capital structure suggest that corporate tax is an important determinant of capital structure, how exogenous changes of the tax rate affect firms’ leverage decisions has not been fully explored. We examine a unique circumstance in which the Chinese government increased the corporate tax rate of firms that had previously received local government tax rebates. The evidence indicates that these firms increased their leverage when the corporate tax rate increased. Further investigation suggests that the adjustment of leverage was mostly driven by firms with a high level of access to bank loans.     

Credit rating dynamics and Markov mixture models

Despite mounting evidence to the contrary, credit migration matrices, used in many credit risk and pricing applications, are typically assumed to be generated by a simple Markov process. Based on empirical evidence, we propose a parsimonious model that is a mixture of (two) Markov chains, where the mixing is on the speed of movement among credit ratings. We estimate this model using credit rating histories and show that the mixture model statistically dominates the simple Markov model and that the differences between two models can be economically meaningful. The non-Markov property of our model implies that the future distribution of a firm’s ratings depends not only on its current rating but also on its past rating history. Indeed we find that two firms with identical current credit ratings can have substantially different transition probability vectors. We also find that conditioning on the state of the business cycle or industry group does not remove the heterogeneity with respect to the rate of movement. We go on to compare the performance of mixture and Markov chain using out-of-sample predictions.     

Dominant institutional owners and firm value

This research analyzes the impact of control by dominant institutional owners (banking institutions and investment funds) on firm value. The analysis considers the level of voting rights in the hands of the dominant institutional owner and other large shareholders. The results reveal a different effect on value depending on whether the dominant institutional investor is a banking institution or an investment fund. Moreover, the results show that the presence of other large shareholders affects firm value when a dominant institutional owner controls the firm.     

Credit rating dynamics in the presence of unknown structural breaks

In many credit risk and pricing applications, credit transition matrix is modeled by a constant transition probability or generator matrix for Markov processes. Based on empirical evidence, we model rating transition processes as piecewise homogeneous Markov chains with unobserved structural breaks. The proposed model provides explicit formulas for the posterior distribution of the time-varying rating transition generator matrices, the probability of structural break at each period and prediction of transition matrices in the presence of possible structural breaks. Estimating the model by credit rating history, we show that the structural break in rating transitions can be captured by the proposed model. We also show that structural breaks in rating dynamics are different for different industries. We then compare the prediction performance of the proposed and time-homogeneous Markov chain models.     

Evidence on the effects of bank competition on firm borrowing and investment

This paper presents evidence on the financial and real effects of bank competition using a large panel of privately held firms. I trace the firm-level impact of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, which increased the competitiveness of U.S. banking markets. Following the deregulation, newly formed firms used significantly less external debt, were smaller, and realized higher returns on assets, consistent with their investing less due to greater financial constraints. These effects diminish as firms age, ultimately reversing sign. The differential impact that banking market reforms may have on newer and more established firms is underscored.     

DETERMINANTS OF CAPITAL STRUCTURE IN BUSINESS START‐UPS: THE ROLE OF NONFINANCIAL STAKEHOLDER RELATIONSHIP COSTS

According to the finance literature, nonfinancial stakeholders (NFS), such as customers, suppliers, and employees, take into account their expected liquidation costs when dealing with a firm. In this framework, firms can influence their probability of liquidation by choosing an appropriate capital structure. Also, the literature suggests NFS bargaining power may affect firm financing decisions. In the current article we investigate these ideas for initial financing decisions by business start‐ups, where ex ante failure risk is high and NFS must decide whether to make relationship‐specific investments. We find that start‐ups imposing larger costs on their NFS following liquidation significantly reduce leverage. This effect is strengthened when suppliers have greater bargaining power. We also document a marginally negative effect of NFS liquidation costs on the proportion of bank loans. Finally, business start‐ups rely less on bank loans when customers and suppliers are in a powerful bargaining position.