Interest Rates and Credit Risk

Javier Suarez and González-Aguado, Carlos
Authors registered in the RePEc Author Service: Carlos González-Aguado ()

No 8398, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: 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 cut 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: Credit risk; Firm dynamics; Interest rates; Search for yield; Short-term debt (search for similar items in EconPapers)
JEL-codes: E52 G32 G33 (search for similar items in EconPapers)
Date: 2011-05
New Economics Papers: this item is included in nep-cba and nep-mac
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

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Journal Article: Interest Rates and Credit Risk (2015)
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