Firm Diversification and Equilibrium Risk Pooling: The Korean Financial Crisis as a Natural Experiment

Abstract:     
We use the Korean Financial Crisis as a natural laboratory for examining interactions among firm diversification, equilibrium capital structure and tail probability events. When the crisis hit in 1997, several major firms, including a large number of highly leveraged conglomerates (Chaebols), experienced bankruptcies. In a simple model, we show how diversified Chaebols are able to obtain higher levels of equilibrium debt than non-Chaebol firms (ceteris paribus) due to protective effects of cosigners. In the event of an unanticipated shock, the model predicts a systematic change in relative bankruptcy risks of Chaebol firms. To examine this implication, we first estimate a model of equilibrium debt determination for a sample of Korean manufacturing firms for the years 1991-1994. We then introduce a new empirical methodology that allows us to decompose equilibrium debt into demand, supply and Chaebol-specific factors. To improve our understanding of the mechanisms driving the widespread failures, we use decomposed debt to estimate a bankruptcy prediction model for the post-crisis period. Our main finding is that benefits from shared risks may, in fact, lead to shared vulnerability: The primary cause of bankruptcies of Chaebol firms was not idiosyncratic leverage, but instead leverage systematically related to their greater equilibrium access to debt during normal times.

Keywords: Asian Financial Crisis, Korean Chaebols, Firm Diversification, Bankruptcy

JEL Classification: G33, G32, G00

working papers series