The Role of Leverage in Firm Solvency: Evidence from Bank Loans
32 Pages Posted: 25 Mar 2015
Date Written: October 23, 2014
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.
Keywords: economic and financial crisis, firms leverage, banks non-performing loans, insolvency
JEL Classification: G01, G21, G31, G33
Suggested Citation: Suggested Citation