Bank default risk propagation along supply chains: Evidence from the U.K.

Abstract

How does banks' default risk affect the probability of default of non-financial businesses? The literature has addressed this question by focusing on the direct effects on the banks' corporate customers - demonstrating the existence of bank-induced increases in firms' probabilities of default. However, it fails to consider the indirect effects through the interfirm transmission of default risk along supply chains. Supply chain relationships have been shown to be a powerful channel for default risk contagion. Therefore, the literature might severely underestimate the overall impact of bank shocks on default risk in the business economy. Our paper fills this gap by analyzing the direct as well as the indirect impact of banks' default risk on firms' default risk in the U.K. Relying on Input-Output tables, we devise methods that enable us to examine this question in the absence of microeconomic data on supply chain links. To capture all potential propagation channels, we account for horizontal linkages between the firm and its competitors in the same industry, and for vertical linkages, both between the firm and its suppliers in upstream industries and between the firm and its customers in downstream industries. In addition, we identify trade credit and contract specificity as significant characteristics of supply chains, which can either amplify or dampen the propagation of default risk. Our results show that the banking crisis of 2007-2008 affected the non-financial business sector well beyond the direct impact of banks' default risk on their corporate clients.