Financial Health and Airline Safety

Abstract

Theoretical models suggest that firms may pursue riskier strategies in times of financial distress. For example, financially weak firms may compromise safety and quality to maximize current period profits. If the riskier strategy fails, then the stockholders are content to hand over the bankrupt firm to the debt holders. Despite much interest, there is little, if any, empirical evidence that relates financial health to the risk-taking behavior of firms. We explore this relationship for the airline industry. Using bond ratings to proxy for financial health and airline mishaps to measure safety, we find a significant correlation: airlines with higher quality bond ratings are less likely to experience mishaps than airlines with lower quality ratings. On average, an airline with an investment grade bond rating has a 25% lower probability of a mishap than an airline with a below investment grade bond rating. The findings imply that the Federal Aviation Administration (FAA) should shift part of its inspection and surveillance resources from financially strong airlines to financially weak airlines. Further, reliance on readily available bond ratings makes it easy to implement these recommendations.

JEL Classification: G32, G38, L93