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Financial innovation and corporate default rates

In: Proceedings of the IFC Conference on "Measuring financial innovation and its impact", Basel, 26-27 August 2008

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  • Samuel Maurer
  • Luu Nguyen
  • Asani Sarkar
  • Chenyang Wei

Abstract

Corporate default rates have been unusually low in recent years, both relative to historical rates and to forecasts of economists and ratings agencies. We examine the hypothesis that financial innovation has provided new financing options for distressed firms, which are consequently able to postpone or avoid default. Consistent with this hypothesis, we find that in recent years the incidence of early default has decreased, even after controlling for business cycle effects. Next, we estimate a model for predicting aggregate monthly defaults and find that, if financial innovation is ignored, there is evidence of a structural break in recent years. Focusing on the most recent sample, we find that increased structured financing (i.e., high-yield CLO and CDO issuances) predict increased distance to default. Moreover, the component of distance to default explained by financing is positively related to future defaults, whereas the residual unexplained part is negatively related to future defaults. In contrast, increased traditional financing (i.e., banks’ commercial and industrial lending and commercial paper issuance) is negatively related to the distance to default. These results are consistent with more stringent monitoring of borrowers by traditional lenders. However, incorporation of both structured and traditional financing improves the default prediction model, especially in the recent sample. Our findings highlight the important role of financing in credit risk modeling and management.
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Suggested Citation

  • Samuel Maurer & Luu Nguyen & Asani Sarkar & Chenyang Wei, 2009. "Financial innovation and corporate default rates," IFC Bulletins chapters,in: Bank for International Settlements (ed.), Proceedings of the IFC Conference on "Measuring financial innovation and its impact", Basel, 26-27 August 2008, volume 31, pages 322-343 Bank for International Settlements.
  • Handle: RePEc:bis:bisifc:31-23
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    1. Hui Chen, 2010. "Macroeconomic Conditions and the Puzzles of Credit Spreads and Capital Structure," Journal of Finance, American Finance Association, vol. 65(6), pages 2171-2212, December.
    2. Fischer, Edwin O & Heinkel, Robert & Zechner, Josef, 1989. " Dynamic Capital Structure Choice: Theory and Tests," Journal of Finance, American Finance Association, vol. 44(1), pages 19-40, March.
    3. Duffie Darrell & Rahi Rohit, 1995. "Financial Market Innovation and Security Design: An Introduction," Journal of Economic Theory, Elsevier, vol. 65(1), pages 1-42, February.
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