Evidence on the Importance of Market Competition in Distress Propagation

Joint with S. Johnson, Wei Wu

July 2023

We build a competition network of industries, wherein two industries are considered connected if they share a common market leader, a multi-industry firm that competes actively in both industries as a major player. Drawing on a quasi-experimental setting induced by the local-natural-disaster occurrences, we find that firms affected by disasters face heightened distress risk levels, prompting both these firms and their industry rivals to engage in more aggressive competition by reducing profit margins, even leading to a collapse of "competitive balance." Consequently, untreated firms in the same industry also face an increased likelihood of covenant violations or defaults in the short run, particularly in tradable industries or those with high entry barriers, high inventories, or high financial constraints. Quasi-experimental settings induced by other prominent events provide consistent findings. Furthermore, we observe that distress risk shocks and the subsequent changes in competition intensity can extend beyond the boundaries of a single industry. This propagation occurs primarily through financially-consolidated common market leaders, particularly in tradable industries or those with high financial constraints.