Strategic Default and Equity Risk Across Countries

When a firm is in financial distress, its shareholders and debt holders may benefit from a debt renegotiation to avoid an inefficient bankruptcy or liquidation. The prospect of a debt reduction through a renegotiation may, however, induce shareholders to default even if the firm is solvent. The view that shareholders may default for strategic rather than for solvency reasons has proved useful in understanding, among other things, the theoretical determinants of corporate bond spreads, dividend policies, the optimal debt structure, and the valuation of debt and equity.

This paper asks whether the option of shareholders to default strategically on the firm's debt explains differences in firms' equity risk across countries. Our claim is that the risk of equity should be lower for firms that operate in countries where the insolvency procedure favours debt renegotiations. The reason is that the prospect of a favourable debt renegotiation not only increases the expected payoff to shareholders in default, but also induces them to anticipate the timing of default. As a result, the equity risk becomes less sensitive to the firm's cash flow risk. Our findings point to a new and important measurable determinant of the cross-country differences in equity risk. While existing literature relates the cross-country differences in equity risk to the country's rule of law, financial development and corporate governance, we relate equity risk to the shareholder's opportunism induced by the insolvency code.

This paper argues that the prospect of strategic default on the firm's debt affects the firm's equity beta, and that this effect weakens in countries where debt contracts cannot be easily renegotiated. We find evidence supporting these predictions using a recent international survey of insolvency procedures to measure debt renegotiation frictions. We also find that the prospect of strategic default affects the firm's total volatility. Overall, the evidence in this paper suggests that the bankruptcy code is an important determinant of the differences in cost of capital across countries through its effects on the firms' strategic default incentives. A natural extension of our analysis is to study cross-country differences in the tax treatment of bankruptcy, in order to identify other important determinants of shareholders' expected payoff in default. The non-linear effects of the strategic default option may also have important implications for the skewness of stock returns, a topic worth studying in future research.

The full research paper is available for download below.