Costly External Finance, Liquidity Risk, and Default Risk

37 Pages Posted: 18 Mar 2011

Date Written: March 15, 2011

Abstract

I use the 2007-2008 financial crisis to gauge how internal financial resources and external financial constraints mitigate or worsen the impact of the crisis on default risk of US industrial firms. I identify heterogeneity in short-term funding needs at the onset of the crisis by exploiting ex-ante variation in long-term debt structure. I also compute excess cash reserves with pre-crisis data to measure exogenous cross-firm variations in internal financial resources. A differences-in-differences method is implemented to assess the mitigating effect of internal financial resources during the crisis, controlling for firm fixed effects and firm characteristics related to default risk. Consistent with the predictions in He and Xiong (2010) and Morris and Shin (2009), the results show that firms that need not to refinance long-term debt in 2008 see an increase of 104 basis points in CDS spreads following the onset of the crisis, while firms, which need to refinance long-term debt equivalent to 4.6% of total assets, experience an additional 53 basis point increase. Holding extra cash reserves equivalent to 9.6% of total assets dampens the increase by 28 basis points. In addition, the impact of the crisis is substantially severe for financially constrained firms. A financially constrained firm that needs not to refinance long-term debt in 2008 sees an additional increase of 129 basis points in CDS spreads comparing to a similar but financially unconstrained firm. Moreover, the relation between pre-crisis internal financial positions and post-crisis default risk becomes stronger for financially constrained firms. That same financially constrained firm, if needs to refinance long-term debt equivalent to 5.1% of total assets, will experience an additional 117 basis point increase in CDS spreads.

Keywords: default risk, liquidity risk, financial crisis, short-term debt, cash reserves

JEL Classification: G12, G13, G14, G32, G33

Suggested Citation

Yang, Jun, Costly External Finance, Liquidity Risk, and Default Risk (March 15, 2011). Available at SSRN: https://ssrn.com/abstract=1786155 or http://dx.doi.org/10.2139/ssrn.1786155

Jun Yang (Contact Author)

Bank of Canada ( email )

234 Wellington Street
Ontario, Ottawa K1A 0G9
Canada

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