The role of leverage in firm solvency: evidence from bank loans

The two recessions that have hit Italy since the end of 2008 have raised the share of non-performing loans to businesses in banks� portfolios substantially. In this paper we evaluate to what extent the deterioration of credit quality was due not only to the decline in firms� sales during the contraction of economic activity, but also to the level of firms� financial debt at the onset of the first recession. Our results show that, other things being equal, a ten percentage point increase in leverage is associated with a higher probability of default of almost one percentage point. Moreover, the adverse impact of a fall in sales on a firm�s solvency is almost four times greater for firms in the highest quartile of the leverage distribution than for firms in the first quartile. These findings confirm that firms� financial structure can be a powerful amplifier of macroeconomic shocks. A higher level of leverage reduces firms� resilience during a recession, and this in turn weakens the balance-sheets of banks and thus their ability to provide credit.