Corporate bankruptcy and banking deregulation: The effect of financial leverage

Abstract

We investigate the impact of deregulation-induced banking competition on corporate credit risk. Although banking competition does not, on average, affect corporate bankruptcy rates, we find that it causes corporate bankruptcies to increase significantly for high-leverage firms. We show that higher borrowing costs for high-leverage firms post-deregulation and the resulting credit rationing may be key factors behind our findings. The effect of deregulation lasts for up to seven years after the introduction of deregulation and originates mainly from firms that have high short-term debt and are financially constrained. Our results suggest that banking competition, which is expected to expand lending and reduce its cost, may, in fact, create more challenging credit conditions, particularly for firms that are more heavily dependent on external funding.