Insolvency Regimes and Firms' Default Risk Under Economic Uncertainty and Shocks

Gopalakrishnan, Balagopal and Mohapatra, Sanket (2019): Insolvency Regimes and Firms' Default Risk Under Economic Uncertainty and Shocks.

Abstract

One of the arguments often advanced for implementing a stronger insolvency and bankruptcy framework is that it enhances credit discipline among firms. Using a large cross-country firm-level dataset, we empirically test whether a stronger insolvency regime reduces firms' likelihood of defaulting on their debt. In particular, we examine whether it reduces default risk during increased economic uncertainty and various external shocks. Our results confirm that a stronger insolvency regime moderates the adverse effects of economic shocks on firms' default risk. The effects are more pronounced for firms in the top half of the size distribution. We also explore channels through which improved creditor rights influence firms’ default risk, including dependence on external finance, corporate leverage, and managerial ethics. Our main results are robust to an alternative measure of default risk, inclusion of currency and sovereign debt crisis episodes, and alternative estimations.

• Item Type: MPRA Paper
• Language: English
• Keywords: Insolvency; Bankruptcy; Default risk; Economic policy uncertainty; Sovereign debt crisis; Currency crisis
• Subjects: G - Financial Economics > G3 - Corporate Finance and Governance > G30 - General; G - Financial Economics > G3 - Corporate Finance and Governance > G32 - Financing Policy ; Financial Risk and Risk Management ; Capital and Ownership Structure ; Value of Firms ; Goodwill; G - Financial Economics > G3 - Corporate Finance and Governance > G33 - Bankruptcy ; Liquidation

References

Acharya, V. V., Almeida, H., & Campello, M. (2007). Is cash negative debt? A hedging perspective on corporate financial policies. Journal of Financial Intermediation, 16(4), 515–554.

Acharya, V. V., Amihud, Y., & Litov, L. (2011). Creditor rights and corporate risk-taking. Journal of Financial Economics, 102(1), 150–166.

Acharya, V. V., Bharath, S. T., & Srinivasan, A. (2007). Does industry-wide distress affect defaulted firms? evidence from creditor recoveries. Journal of Financial Economics, 85(3), 787–821.

Acharya, V. V., & Subramanian, K. V. (2009). Bankruptcy codes and innovation. The Review of Financial Studies, 22(12), 4949–4988.

Adler, B. E. (1991). Bankruptcy and risk allocation. Cornell L. Rev., 77, 439.

Almeida, H., Hankins, K. W., & Williams, R. (2017). Risk management with supply contracts. The Review of Financial Studies, 30(12), 4179–4215.

Altman, E. I. (1968). Financial ratios, discriminant analysis and the prediction of corporate bankruptcy. The Journal of Finance, 23(4), 589–609.

Andrade, G., & Kaplan, S. N. (1998). How costly is financial (not economic) distress? evidence from highly leveraged transactions that became distressed. The Journal of Finance, 53(5), 1443–1493.

Asness, C. S., Frazzini, A., & Pedersen, L. H. (2019). Quality minus junk. Review of Accounting Studies, 24(1), 34–112.

Baker, S. R., Bloom, N., & Davis, S. J. (2016). Measuring economic policy uncertainty. The Quarterly Journal of Economics, 131(4), 1593–1636.

Beck, T., Demirguc¸-Kunt, A., & Maksimovic, V. (2006). The influence of financial and legal¨ institutions on firm size. Journal of Banking & Finance, 30(11), 2995–3015.

Berger, A. N., Guedhami, O., Kim, H. H., & Li, X. (2018). Economic policy uncertainty and bank liquidity hoarding. Available at SSRN 3030489.

Bergoeing, R., Kehoe, P. J., Kehoe, T. J., & Soto, R. (2002). A decade lost and found: Mexico and Chile in the 1980s. Review of Economic Dynamics, 5(1), 166–205.

Bergoeing, R., Loayza, N., & Repetto, A. (2004). Slow recoveries. Journal of Development Economics, 75(2), 473–506.

Bloom, N. (2009). The impact of uncertainty shocks. Econometrica, 77(3), 623–685.

Bordo, M. D., Duca, J. V., & Koch, C. (2016). Economic policy uncertainty and the credit channel: Aggregate and bank level US evidence over several decades. Journal of Financial Stability, 26, 90–106.

Boumparis, P., Milas, C., & Panagiotidis, T. (2017). Economic policy uncertainty and sovereign credit rating decisions: Panel quantile evidence for the Eurozone. Journal of International Money and Finance, 79, 39–71.

Brogaard, J., & Detzel, A. (2015). The asset-pricing implications of government economic policy uncertainty. Management Science, 61(1), 3–18.

Chava, S., & Roberts, M. R. (2008). How does financing impact investment? the role of debt covenants. The Journal of Finance, 63(5), 2085–2121.

Chi, Q., & Li, W. (2017). Economic policy uncertainty, credit risks and banks’ lending decisions: Evidence from Chinese commercial banks. China Journal of Accounting Research, 10(1), 33–50.

Cho, S.-S., El Ghoul, S., Guedhami, O., & Suh, J. (2014). Creditor rights and capital structure: Evidence from international data. Journal of Corporate Finance, 25, 40–60.

Claessens, S., & Klapper, L. F. (2005). Bankruptcy around the world: explanations of its relative use. American Law and Economics Review, 7(1), 253–283.

Demsetz, H., & Lehn, K. (1985). The structure of corporate ownership: Causes and consequences. Journal of Political Economy, 93(6), 1155–1177.

Dewaelheyns, N., & Van Hulle, C. (2008). Legal reform and aggregate small and micro business bankruptcy rates: evidence from the 1997 Belgian bankruptcy code. Small Business Economics, 31(4), 409.

Djankov, S., McLiesh, C., & Shleifer, A. (2007). Private credit in 129 countries. Journal of Financial Economics, 84(2), 299–329.

Drobetz, W., El Ghoul, S., Guedhami, O., & Janzen, M. (2018). Policy uncertainty, investment, and the cost of capital. Journal of Financial Stability, 39, 28–45.

Eckbo, B. E., & Thorburn, K. S. (2003). Control benefits and CEO discipline in automatic bankruptcy auctions. Journal of Financial Economics, 69(1), 227–258. Eisdorfer, A. (2008). Empirical evidence of risk shifting in financially distressed firms. The Journal of Finance, 63(2), 609–637.

Fan, J. P., Huang, J., & Zhu, N. (2013). Institutions, ownership structures, and distress resolution in China. Journal of Corporate Finance, 23, 71–87.

Gertler, M., & Bernanke, B. (1989). Agency costs, net worth and business fluctuations. In Business cycle theory. Edward Elgar Publishing Ltd.

Gilson, S. C. (1997). Transactions costs and capital structure choice: Evidence from financially distressed firms. The Journal of Finance, 52(1), 161–196.

Gormley, T. A., & Matsa, D. A. (2014). Common errors: How to (and not to) control for unobserved heterogeneity. The Review of Financial Studies, 27(2), 617–661.

Harvey, C. R., & Liu, Y. (2019). Cross-sectional alpha dispersion and performance evaluation. Journal of Financial Economics.

Hirshleifer, D., & Thakor, A. V. (1992). Managerial conservatism, project choice, and debt. The Review of Financial Studies, 5(3), 437–470.

Huang, P., Louwers, T. J., Moffitt, J. S., & Zhang, Y. (2008). Ethical management, corporate governance, and abnormal accruals. Journal of Business Ethics, 83(3), 469–487.

Huang, Y., Elkinawy, S., & Jain, P. K. (2013). Investor protection and cash holdings: Evidence from US cross-listing. Journal of Banking & Finance, 37(3), 937–951.

Husted, B. W. (2007). Agency, information, and the structure of moral problems in business. Organization Studies, 28(2), 177–195.

La Porta, R., Lopez-de Silanes, F., Shleifer, A., & Vishny, R. W. (1997). Legal determinants of external finance. The Journal of Finance, 52(3), 1131–1150.

MacKie-Mason, J. K. (1990). Do taxes affect corporate financing decisions? The journal of finance, 45(5), 1471–1493.

Nagar, V., Schoenfeld, J., & Wellman, L. (2019). The effect of economic policy uncertainty on investor information asymmetry and management disclosures. Journal of Accounting and Economics, 67(1), 36–57.

Pastor, L., & Veronesi, P. (2012). Uncertainty about government policy and stock prices. Journal of Finance, 67(4), 1219–1264.

Petersen, M. A. (2009). Estimating standard errors in finance panel data sets: Comparing approaches. The Review of Financial Studies, 22(1), 435–480.

Rajan, R., & Zingales, L. (1998). Financial development and growth. American Economic Review, 88(3), 559–586.

Reinhart, C. M., & Reinhart, V. R. (2015). Financial crises, development, and growth: a long-term perspective. The World Bank Economic Review, 29(suppl 1), S53–S76.

Reinhart, C. M., & Rogoff, K. S. (2009). This time is different: Eight centuries of financial folly. Princeton University Press.

Rodano, G., Serrano-Velarde, N., & Tarantino, E. (2016). Bankruptcy law and bank financing. Journal of Financial Economics, 120(2), 363–382.

Seifert, B., & Gonenc, H. (2012). Creditor rights and R&D expenditures. Corporate Governance: An International Review, 20(1), 3–20.

Van Oosterhout, J., Heugens, P. P., & Kaptein, M. (2006). The internal morality of contracting: Advancing the contractualist endeavor in business ethics. Academy of Management Review, 31(3), 521–539.

World Bank. (2019). Ranking & Ease of Doing Business Score. Retrieved February, 23.

Zwiebel, J. (1995). Corporate conservatism and relative compensation. Journal of Political Economy, 103(1), 1–25.