Inside Debt and Debt Incentives: Evidence from the 2008 Financial Crisis

Abstract:     
We study the rationale for firms’ use of inside debt by exploiting the relation between firms’ default risk and inside debt (pension and deferred compensation). The classical principal-agent theory indicates that the agency costs of debt are higher when the firm’s debt is riskier. We test whether firms that are likely to face more severe agency problems of debt provide more debt incentives. We provide evidence that less distressed firms use more inside debt. The 2008 financial crisis significantly increases firms’ default risk. This exogenous shift in firms’ default risk offers an opportunity to provide evidence on the potential causal relation between default risk and inside debt. Based on a difference-in-differences approach, we find that firms with increased default risk during the crisis period increase their inside debt significantly less than those firms with decreased default risk. Overall, we find little evidence to support the hypothesis that inside debt is used to alleviate the agency costs of debt. Anecdotal evidence suggests that personal tax concerns appear to be an important determinant for inside debt usage.

Number of Pages in PDF File: 34

Keywords: Inside debt, Compensation, Financial crisis, Debt incentives, Equity incentives

JEL Classification: G34, G38, M52

working papers series