Corporate equity and fi nancial stability: An approach based on net worth at risk

This article is based on a study conducted jointly by the Deutsche Bundesbank, the Banco d’Espana, the Centrale dei Bilanci (Italy) and the Banque de France under the aegis of the European Committee of Central Balance Sheet Offi ces.1 It looks at companies’ resilience in the event of an exceptional cyclical shock. The article starts by outlining the economic role of equity capital, which lies at the heart of the relationship between risk and return. It can be examined from two main angles, either as a financing instrument or as a buffer in the event of a shock. This study focuses on this second function, looking at it from a meso-economic perspective for which the use of central balance sheet offices is particularly well suited. It sets out to describe the implications of a crisis situation in terms of minimum capital requirements. A comparison is drawn between the situation of manufacturing sector companies in the four countries under review over the period 1987-2002 by means of several traditional indicators (income, equity capital), which resulted in the computation of a Net Worth at Risk (NWaR) indicator. The NWaR figures are calibrated on the basis of an analysis of the distribution of accounting losses (in particular at the 90th and 95th percentiles) calculated using company samples. They indicate the minimum capital that would be required in order to absorb any losses in the event of very unfavourable economic conditions. The difference between NWaR and the observed level of equity capital gives us an indication of the number of companies for which the default rate is likely to increase significantly in a crisis situation. The proportion of companies that appear fragile in the event of a severe economic downturn is around 40%, as against 20% in a “normal” situation. However, this statistical analysis needs to be put into perspective. In practice, only a minority of companies default, since the majority of them benefit from protective measures implemented by their shareholders, managers and creditors to enable them to weather the downturn and revive their activity. In spite of the limitations of this indicator (which are also discussed in the study), these findings will draw the attention of bank and company managers to the need to make financial projections and credit risk assessments both in normal business conditions and crisis situations. An approach based on net worth at risk sheds light on the determinants of a sound financing structure and encourages the development of an active approach to preventing corporate financing problems.