World Bank Group

02/22/2021 | Press release | Distributed by Public on 02/22/2021 11:52

Corporate bankruptcy and banking competition: the effect of financial leverage

In our recent working paper, we study the effect of a change in banking competition on firms' bankruptcy rates in the United States.

We know from empirical evidence that banking competition typically decreases interest rates, makes it easier for firms to access bank credit (Boyd and De Nicolo 2005), and leads to economic growth (Jayaratne and Strahan, 1996). Kerr and Nanda (2009) further show that following episodes of banking deregulation, entry and exit of firms increase, reinforcing Schumpeterian competition and increasing firms' innovativeness (Chava et al. 2013).

However, there are also drawbacks linked to banking competition. Indeed, banking competition could reduce banks' charter values, which in turn would decrease incentives to monitor and screen borrowers (Keeley 1990; Hellmann et al. 2000). Furthermore, banking competition might lead to a deterioration of lending relationships (Petersen and Rajan 1994; Petersen and Rajan 1995). In our work, we show that bankruptcy rates of high-leverage firms rise after an increase in banking competition.

To document this result, we use the passage of the Interstate Banking and Branching Efficiency Act (IBBEA) as an exogenous shock to banking competition.

Historically, the US banking sector has been very segmented. Banks used to face restrictions that prevented them from expanding their activities to other states. IBBEA deregulated the process to establish out-of-state bank branches. However, although the IBBEA removes federal restrictions on interstate bank expansion, it also allows states to determine how this is implemented.

The US Congress passed the IBBEA regulation in 1994, which was implemented by state legislators in the following years. During the implementation period, state legislators could adopt provisions that limit competition from out-of-state banks. While most states deregulated between 1995 and 1997, some states continued changing the IBBEA provisions until 2005. This resulted in a staggered implementation of the IBBEA, with different states imposing different restrictions. Following the implementation of the IBBEA, the number of branches established by out-of-state banks sharply increased, thus increasing competition in the banking industry (Johnson and Rice 2008).

Exploiting the IBBEA implementation, we analyze bankruptcy rates in the years that followed. We find that deregulation does not impact all firms in the same way. While the bankruptcy rates of most firms are not affected by higher banking competition, high-leverage firms suffer much higher bankruptcy rates. We classify high-leverage firms as those for which financial leverage is in the highest quartile. Our findings are robust to different thresholds.

Figure 1: Bankruptcy Rates and IBBEA Implementation

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Figure 1 presents the average bankruptcy rates for low-leverage (blue line) and high-leverage (green line) firms in each quarter. It also shows the average value of the deregulation index (red line) in our sample. State legislators implemented the IBBEA in different quarters, with different barriers to entry that changed over time. For these reasons, the average deregulation index increased over time.

We find that the bankruptcy rates of low-leverage firms did not increase after the implementation of the IBBEA, and only spiked during the dot-com bubble. However, the bankruptcy rates of high-leverage firms experienced a rapid increase following IBBEA implementation. The increase in high-leverage firms' bankruptcy rates follows IBBEA deregulation with a lag of a few quarters. The bankruptcy rates of high-leverage firms went from an average of less than 1% before IBBEA deregulation to a peak of almost 2.5% with the bursting of the dot-com bubble.

Figure 2: Bankruptcy Rates before and after IBBEA Implementation

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The bankruptcy rates plotted in figure 2 reinforce the evidence presented in figure 1. Indeed, figure 2 presents average bankruptcy rates for low-leverage (blue line) and high-leverage (green line) firms calculated in the quarters before and after IBBEA deregulation. The average bankruptcy rate for low-leverage firms did not change before and after the increase in banking competition. However, the average bankruptcy rate for high-leverage firms more than doubled after the IBBEA deregulation took place.

In the paper, we further investigate the effects of debt maturity and bank lending on bankruptcy rates. We find that bankruptcy rates of high-leverage firms were particularly exacerbated among firms with high levels of short-term debt. We also find that, following the IBBEA, syndicated loans for highly leveraged firms decreased. We document that syndicated loans that were taken with the purpose of mergers and acquisitions decreased for such firms after the IBBEA. Our results suggest that this could be damaging for firms' survival in the long run, as large companies often rely on acquiring small and innovative firms.

Granted that banking competition generally increases economic growth (Jayaratne and Strahan 1996), we highlight some possible drawbacks of increases in banking competition. Concretely, we find that the credit risk of high-leverage firms rises following increases in banking competition. Credit risk is even higher for firms more exposed to rollover risk (i.e., firms with high levels of short-term debt). This finding could be explained by the loss of relationship lending for high-leverage firms during periods of increased banking competition. Our results suggest that to avoid this downside of increased competition, policy makers should work on measures to mitigate the risk of high-leverage firms during episodes of deregulation.

REFERENCES

Boyd, J. and De Nicolo, G. (2005). The theory of bank risk-taking and competition revisited. The Journal of Finance, 60(3):1329-1343.

Chava, S., Oettl, A., Subramanian, A., and Subramanian, K. V. (2013). Banking deregulation and innovation. Journal of Financial Economics, 109(3):759-774.

Hellmann, T. F., Murdock, K. C., and Stiglitz, J. E. (2000). Liberalization, Moral Hazard in Banking, and Prudential Regulation: Are Capital Requirements Enough? The American Economic Review, 90(1):147-165.

Jayaratne, J. and Strahan, P. E. (1996). The Finance-Growth Nexus: Evidence from Bank Branch Deregulation. The Quarterly Journal of Economics, 111(3):639-670.

Johnson, C. A. and Rice, T. (2008). Assessing a Decade of Interstate Bank Branching. Washington and Lee Law Review, (1):73-128.

Keeley, M. C. (1990). Deposit Insurance, Risk, and Market Power in Banking. The American Economic Review, 80(5):1183-1200.

Kerr, W. R. and Nanda, R. (2009). Democratizing entry: Banking deregulations, financing constraints, and entrepreneurship. Journal of Financial Economics, 94(1):124-149.

Petersen, M. A. and Rajan, R. G. (1994). The Benefits of Lending Relationships: Evidence from Small Business Data. The Journal of Finance, 49(1):3-37.

Petersen, M. A. and Rajan, R. G. (1995). The Effect of Credit Market Competition on Lending Relationships. The Quarterly Journal of Economics, 110(2):407-443.