Product market competition and credit risk
This paper investigates whether product market competition indicators can be used to enhance bankruptcy prediction models. Using a sample of Italian private firms in the period 2009-2014, we test if an increase in product market competition (measured by product market fluidity) is associated to higher likelihood of financial default. The study also assesses whether prediction models using competition measures have higher predictive ability, compared to those using standard industry controls.
The empirical findings show that the product market fluidity has a positive and significant association with the likelihood of bankruptcy. The findings also show that the prediction model augmented with fluidity is more accurate and exhibit lower levels of either Type I and Type II errors. Type I errors are of particular importance as they are related to the misclassification of default firms as healthy firms. This error is responsible of severe investment losses and banks’ non-performing loans.
This research can contribute to prior research on bankruptcy prediction, as it provides evidence that prediction models can be improved by including firm-specific competitive pressure measures. Moreover, it can also contribute to governance and internal control studies. Monitoring competition can be critical for the internal control systems, as it could provide an early warning indicator of potential financial distress. In this perspective, the study can contribute to the current debate on legislative reforms across the EU regarding the business insolvency and the early identification of financial default.
Keywords: Financial distress, Competition, Z-Score, Product Market Fluidity, Credit risk
