Working Paper: CEPR ID: DP8398
Authors: Carlos González-Aguado; Javier Suarez
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.
Keywords: credit risk; firm dynamics; interest rates; search for yield; short term debt
JEL Codes: E52; G32; G33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Interest rate rises (E43) | Aggregate default rate increase (E43) |
| Interest rate cuts (E43) | Aggregate default rate decrease (E43) |
| Interest rate rises (E43) | Temporary increase in leverage and credit risk (F65) |
| Interest rate cuts (E43) | Easier adjustment of leverage (F32) |
| Higher interest rates (E43) | Lower target leverage across all firms (G32) |
| Leverage (G32) | Default rate influenced by moral hazard problem (E43) |