Impaired Bank Health and Default Risk

Empirical studies in corporate finance have long been interested in the role of banks in reducing the costs of financial distress. The purpose of this paper is to investigate how various measures of bank health and how defaults of major trading partners affected the probability of bankruptcy among medium-size firms in Japan. Using probit models, we examine the causes of bankruptcy for unlisted Japanese companies in the late 1990s and early 2000s. The environment and events in Japan provide a "natural experiment" that allows the empirical test. We find that several measures on bank-specific financial health have significant impacts on a borrower's probability of bankruptcy, even when observable characteristics relating to these borrower's financial variables are controlled for. In particular, a close bank-firm relationship--which usually reduces the probability of bankruptcy--exacerbates the impacts of a financial crisis, which substantially damages other bank health measures as well.