Highly indebted companies became a talking point in the 2007–10 financial crisis. How did so many companies—including corporate giants such as General Motors, which had an accounting leverage of more than 34 times and debt of more than $172 billion before its December 2008 bailout—take on so much risk?
One explanation could have to do with pricing. Companies that rarely change the price of their products or services are more likely to find themselves short of cash than those that are more flexible on pricing. Consequently, when credit is flowing freely, the former are more likely to borrow, according to research by University of Maryland’s Francesco D’Acunto, University of California at Berkeley’s Ryan Liu, University of British Columbia’s Carolin Pflueger, and Chicago Booth’s Michael Weber.
Most companies have prices that range from flexible to “sticky.” When prices are sticky, they don’t change, regardless of fluctuations in manufacturing costs or consumer demand. Flexible prices, by contrast, can be adjusted with market shortages or surpluses.
When credit is tight, companies with flexible prices have higher debt levels—but when more credit is available, companies with inflexible prices lever up. That’s because companies with the stickiest prices are the most financially constrained. So when offered credit, they take on more debt.
Companies with "sticky" pricing jump at an opening to borrow
Grouping companies by the level of flexibility in their product pricing, the researchers find that companies with more fixed, or sticky, pricing started taking on more debt when a change in US law eased restrictions.
The researchers analyzed monthly prices from a subsample of S&P 500 companies from 1982 to 2014. They focused in particular on what happened after legislation, namely the federal Riegle-Neal Interstate Banking and Branching Efficiency Act, impacted US companies’ access to credit.
When the IBBEA took effect in 1994, it removed many of the federal restrictions on interstate bank expansion and dramatically reshaped the banking landscape in affected states. Between then and June 1, 1997, all 50 states and the District of Columbia allowed out-of-state banks to operate in their jurisdictions. And as competition heated up, banks significantly increased the amount of credit they extended to customers.
The data suggest that companies’ pricing strategies had some bearing on their financial leverage. Before the IBBEA passed, companies with the most-rigid prices had long-term leverage ratios of roughly 10 percent, while companies with much more flexible prices had ratios of closer to 30 percent. But after the IBBEA passed, companies with rigid prices took on more bank debt, cutting in half the gap in leverage between flexible and “sticky” companies.
Price flexibility, the researchers note, is a persistent feature over time, so might help explain historical patterns of leverage.