Interest Rates and Credit Risk

52 Pages Posted: 10 Jun 2019

See all articles by Carlos González Aguado

Carlos González Aguado

Comisión Nacional del Mercado de Valores (CNMV)

Javier Suarez

Centre for Monetary and Financial Studies (CEMFI); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Date Written: 2011


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 cuts 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: interest rates, short-term debt, search for yield, credit risk, firm dynamics

JEL Classification: G32, G33, E52

Suggested Citation

González Aguado, Carlos and Suarez, Javier, Interest Rates and Credit Risk (2011). CNMV Working Paper No. 46, Available at SSRN: or

Carlos González Aguado (Contact Author)

Comisión Nacional del Mercado de Valores (CNMV) ( email )

C/ Miguel Ángel, 11
Madrid, Madrid 28010

Javier Suarez

Centre for Monetary and Financial Studies (CEMFI) ( email )

Casado del Alisal 5
28014 Madrid
+34 91 429 0551 (Phone)
+34 91 429 1056 (Fax)

Centre for Economic Policy Research (CEPR)

United Kingdom

European Corporate Governance Institute (ECGI)

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels


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