A commonly held view is that adverse macroeconomic shocks are greatly amplified when firms are financially unsound. For example a large adverse macroeconomic shock will trigger the bankruptcy of highly levered firms. When it does not trigger bankruptcies, this shock will create a debt overhang amongst highly levered firms, slowing down investment. A related amplification effect goes through financial firms. Indeed when banks are financially unsound, they have poor incentives to identify good investment opportunities, and low capacity to make new loans.
Motivated by these observations, Andrew Atkeson (UCLA Economics), Andrea Eisfeldt (UCLA Anderson) and Pierre-Olivier Weill (UCLA Economics) have recently developed a macroeconomic measure of the financial soundness of U.S. firms called Distance to Insolvency, or DI. DI measures a firm’s leverage adjusted for its business risk. This adjustment, which follows insights from the corporate finance literature, is crucial: for example, holding leverage constant, a higher business risk will deteriorate financial soundness because it is now more likely that an adverse shock will be large enough to push the firm into bankruptcy. Professors Atkeson, Eisfeldt and Weill show that DI can be approximated in a very simple way by the inverse of a firm equity volatility. Because data on equity prices are readily available, this allows them to construct and study the distribution of DI in the economy, for the entire universe of U.S. publicly traded firms, for a long time period (1926-2012). They obtain three main empirical findings.
First, they find that over this time period a number of episodes occurred in which the distribution of DI deteriorated sharply. During these episodes, which they call “insolvency crises” the median firm’s DI fell to extremely low levels, normally associated with junk credit rating or worse. They find that the largest recessions in the sample, namely 1932–1933, 1937, and 2008, are indeed episodes of insolvency crises. But the other recessions are not. While this shows that financial frictions matter for the worse U.S. postwar recessions, this also casts some doubt on their importance in most of the other recession.
Second, they find that the sharp deterioration of firms’ DI during the insolvency crisis of 2008 appears to be mainly a result of an increase in business risk. The contribution of a rise in leverage due to excess borrowing or to a fall in asset values is relatively small. This highlights the importance of considering business risk to evaluate macroeconomic financial soundness.
Third, they find that during the recession of 1932-1933, 1937 and 2008, the timing and magnitude of the insolvency crisis were the same for all firms, financial or nonfinancial, large or small. They find that the DI of systemically important financial institutions deteriorated significantly during the crisis, but not before. This highlights that one major challenge for prudential financial regulation is to identify weak financial institutions in advance of financial crises.
For more details see “Measuring the Financial Soundness of U.S. Firms, 1926-2012”.