Proposal Number: SES - 1260953 Principal Investigator: Atkeson, Andrew G.
Building on structural models of credit risk, this project develops a simple, transparent, and robust method for measuring the financial soundness of individual firms using data on their equity volatility. The method proposed for measuring firms' financial soundness is compared to other measures such as those use by Duffie (2011) to measure corporate default risk and those implied by prices for credit default swaps. The primary advantage of the proposed method is that it can be applied over a long time horizon and, across diverse industries because it relies only on readily available equity return data and not on accounting data and/or prices on more recently developed securities such as credit default swaps.
This project retraces quantitatively the history of firms' financial soundness during U.S. business cycles over most of the last century yielding preliminary insights into the role played by financial frictions and financial firms in U.S. recessions. The summary of the main preliminary findings is as follows. First, the largest recessions of the 1926-2011, in 1932-33, 1937, and 2008, were associated with deep insolvency crises, in the sense that the distribution of financial soundness across firms collapsed to abnormally low levels for almost all firms. Insolvency crises did not occur during other recessions, but did occur several times outside recessions, for example during the stock market crash of October 1987. Second, the insolvency crisis of fall 2008 was mainly a result of a sudden increase in the asset volatility, or business risk, facing all firms. Contrary to many theories of financial crises, the contribution of the increase in leverage, induced by a fall in asset values, was relatively small over the time period 2007-2008. Third, in each insolvency crisis, the timing of the financial soundness collapse is almost exactly the same for financial firms as it is for all firms, both financial and non-financial. This finding holds even if we restrict attention to the distribution of financial soundness across the largest financial firms. Thus, during each of our crisis episodes, there is little evidence that the financial soundness of financial firms deteriorated first. Finally, this project also examines the distribution of financial soundness across a smaller group of large financial firms that were at the center of attention of the recent financial crisis: the 18 publicly traded "Stress Test" banks and the six large financial firms that failed during the 2008 crisis (AIG, Bear Stearns, Lehman Brothers, Merrill Lynch, Wachovia, and Washington Mutual). Compared with other firms, both large or small financial firms and large non-financial firms, the financial soundness of these large institutions was quite similar from 1997 to the summer of 2007, but substantially worse for the full four years that have passed since the crisis began. Thus, these government backed large financial firms did not look different than their peers in terms of their financial soundness in advance of the recent financial crises but they do look different afterwards.
The project proposes to extend the preliminary results by broadening the theoretical foundation of the measurement procedure and by extending the empirical work to other countries and time periods to see if similar patterns in the evolution of the distribution of financial soundness across firms are present in other financial crises. The project also proposes to examine the theoretical and empirical relationship between the proposed measure and other financial indicators of firms' financial soundness, with an eye to developing an empirical foundation for practical market signals of firms' and banks' financial soundness.
