Is controlling shareholders' credit risk contagious to firms? — Evidence from China

This paper investigates the contagion effect through shareholdings and the mechanism through which credit risk spreads from controlling shareholders to firms in the Chinese market. We use data on the judicial freeze of controlling shareholders to measure their credit risk and measure firm credit risk by default probabilities estimated from the KMV model. The empirical results show that a higher credit risk of the controlling shareholder is significantly associated with a higher credit risk of the firm in subsequent quarters. The baseline results are robust to a series of robustness tests and are pronounced when applying different methodologies that address potential endogeneity issues. This paper reveals an expropriation channel through which troubled controlling shareholders interfere with firms' efficient running of the business and thus lead to higher firm credit risk. We also provide empirical evidence that lower trust in firms, which shows up as less trade credit and higher borrowing costs, is another possible mechanism through which credit risk spreads from the controlling shareholder to the firm. Finally, we find that the credit risk contagion effect from the controlling shareholder is more pronounced among firms without independent CEOs and non-state-owned enterprises.