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Interest Rates and Credit Risk

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  • González-Aguado, Carlos
  • Suarez, Javier

Abstract

This paper explores the effects of shifts in interest rates on corporate leverage and default. We develop a dynamic model in which the relationship between firms and their outside financiers is affected by a moral hazard problem and entrepreneurs' initial wealth is scarce. The endogenous link between leverage and default risk comes from the lower incentives of overindebted entrepreneurs to guarantee the survival of their firms. Firms start up with leverage typically higher than some state-contingent target leverage ratio, and adjust gradually to it through earnings retention. The dynamic response of leverage and default to cut and rises in interest rates is both asymmetric (since it is easier to adjust to a higher target leverage than to a lower one) and heterogeneously distributed across firms (since interest rates affect the burden of outstanding leverage, which differs across firms). We find that both interest rate rises and interest rate cuts increase the aggregate default rate in the short-run. Instead, higher rates produce lower default rates in the longer run since they induce lower target leverage across all firms. These results help rationalize some of the empirical evidence regarding the so-called risk-taking channel of monetary policy.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 8398.

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Date of creation: May 2011
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Handle: RePEc:cpr:ceprdp:8398

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Related research

Keywords: credit risk; firm dynamics; interest rates; search for yield; short-term debt;

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References

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  1. Jacobson, Tor & Kindell, Rikard & Lindé, Jesper & Roszbach, Kasper F., 2008. "Firm Default and Aggregate Fluctuations," CEPR Discussion Papers 7083, C.E.P.R. Discussion Papers.
  2. Gian Luca Clementi & Hugo Hopenhagn, 2004. "A Theory of Financing Constraints and Firm Dynamics," Working Papers 04-25, New York University, Leonard N. Stern School of Business, Department of Economics.
  3. Raghuram G. Rajan, 2005. "Has Financial Development Made the World Riskier?," Working Papers id:248, eSocialSciences.
  4. Dirk Hackbarth & Jianjun Miao & Erwan Morellec, 2005. "Capital Structure, Credit Risk, and Macroeconomic Conditions," CEMA Working Papers 439, China Economics and Management Academy, Central University of Finance and Economics.
  5. Repullo,R. & Suarez,J., 1996. "Entrepreneurial Moral Hazard and Bank Monitoring: A Model of the Credit Channel," Papers 9604, Centro de Estudios Monetarios Y Financieros-.
  6. Landier, Augustin & Sraer, David & Thesmar, David, 2010. "Going for broke: New Century Financial Corporation, 2004-2006," TSE Working Papers 10-199, Toulouse School of Economics (TSE).
  7. Cover, James Peery, 1992. "Asymmetric Effects of Positive and Negative Money-Supply Shocks," The Quarterly Journal of Economics, MIT Press, vol. 107(4), pages 1261-82, November.
  8. Weise, Charles L, 1999. "The Asymmetric Effects of Monetary Policy: A Nonlinear Vector Autoregression Approach," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 31(1), pages 85-108, February.
  9. Ioannidou, V. & Ongena, S. & Peydro, J.L., 2009. "Monetary Policy, Risk-Taking, and Pricing: Evidence from a Quasi-Natural Experiment," Discussion Paper 2009-31 S, Tilburg University, Center for Economic Research.
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Cited by:
  1. Altunbas, Yener & Gambacorta, Leonardo & Marques-Ibanez, David, 2012. "Do bank characteristics influence the effect of monetary policy on bank risk?," Economics Letters, Elsevier, vol. 117(1), pages 220-222.
  2. Ekin Ayse Ozsuca & Elif Akbostanci, 2012. "An Empirical Analysis of the Risk Taking Channel of Monetary Policy in Turkey," ERC Working Papers 1208, ERC - Economic Research Center, Middle East Technical University, revised Dec 2012.
  3. repec:ecb:ecbwps:20111427 is not listed on IDEAS

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