How Financial Constraints Affect Stock-Price Crash Risk

Financial crises and corporate scandals like those involving Enron, Worldcom, or Fannie Mae have triggered increased academic research into the probability of stock price crashes. Stock price crashes have a material impact on investor welfare, and so are of interest to investors making portfolio investment decisions. By understanding the factors that determine the variations in crash risk, investors can better predict and avoid future stock price crashes. In a recent paper, we examine whether and how financial constraints on companies affect the risk that their stock prices will crash. We define, per Lamont et al. (2001), financial constraints as frictions that prevent firms from funding their desired investments.

We argue that withholding bad news and a high risk of default are two key factors that can make financially constrained firms susceptible to stock price crashes. First, the literature considers withholding bad news as a fundamental cause of stock price crashes (Chang et al., 2017). Managers whose pay rises with the price of their company’s stock have an incentive to inflate that price in the short term by, for example, withholding bad news (Benmelech et al., 2010). Because bad news might increase the cost of issuing equity and debt, managers in financially troubled firms are particularly prone to hide bad news for an extended period to secure external funds. However, even though the amount of bad news that managers are able to hide is limited, they usually cannot anticipate when that limit is reached (He, 2015), given constant and unforeseeable changes in the business environment. Once that limit is reached, though, all the bad news tends to come out, resulting in a sudden, dramatic drop in the price of a company’s stocks, that is, a stock price crash (Jin and Myers, 2006; Hutton et al., 2009). Therefore, the frequency of stock price crashes depends on how much bad news managers withhold. The greater incentives managers have for hiding their firm’s unfavorable information, the higher the future crash risk. Given the limited amount of internal funds available for investments, financially constrained firms need more external funds. To facilitate external financing, they are more likely to withhold bad news and have a higher risk of a future stock price crash.

Second, financially constrained firms need more cash to cover necessary investments and avoid default. However, as external financing is often too expensive for such firms, they must rely on limited internal funds and so are more susceptible to default and a crash resulting from corporate failure. Hence, it follows that financially constrained firms are more prone to stock price crashes. For example, during the financial crisis of 2007-2009, financially constrained firms weren’t able to pursue profitable projects and had to sell assets and forego valuable investments, leading to high default risk (Campello et al., 2010). Such firms are more likely to experience stock price crashes when they default.

Consistent with the above arguments and predictions, we find strong evidence that firms confronted with financial constraints have higher future stock price crash risk. We also check the robustness of such finding in two quasi-experimental settings: the collapse of the junk bond market in 1989 and the internet bubble in 1998-2000. In the quasi-natural experiments, stock price crash risk was significantly higher (lower) in periods when firm financial constraints wee exogenously exacerbated (eased) by the collapse of the junk bond market (by the internet bubble). This substantiates our causal inference that financial constraints lead to high future stock price crash risk. Our additional analysis further reveals that financial constraints are associated with crash risk as far as three years in the future.

We also examine whether and how the stock price crash risk of financially constrained firms varies when such firms pursue earnings management, have weak corporate governance, avoid taxes, or receive a low credit rating from the Standard & Poor’s rating agency. Under an accrual system of accounting, a firm’s financial performance is based on earnings, which comprise accruals and cash flow. While firm management is responsible for giving shareholders earnings estimates, the subjectivity of those estimates provide managers with a way to hide bad news. Zhu (2016) argues that managers seeking to withhold bad news are inclined to make aggressive income-increasing accrual estimates. That makes it more difficult for outside investors to discover hidden bad news, thus providing managers with strong incentives to manage accruals upwards to conceal bad news. So we expect that earnings management aggravates future crash risk for financially constrained firms, and our empirical results confirm this expectation.

Bad news is also more likely to arise when there is agency conflict between shareholders and firm management. Such bad news might be attributed to managerial rent extraction or other self-interested behavior. Concerns about job prospects, personal reputation, the value of stock options, and bonus plans (Jiang et al., 2013) give managers an incentive to withhold bad news. Strong corporate governance puts management under intense monitoring (Ashbaugh-Skaife et al., 2006) and reduces their ability to hide bad news (Karamanou and Vafeas, 2005), thereby mitigating future stock price crash risk (Kim and Zhang, 2016). Accordingly, we predict that managers in a well-governed, financially constrained firm are less likely to withhold bad news, and so, their firm’s future crash risk tends to be lower. Our empirical analysis, involving 16 different corporate governance measures, supports that prediction.

When firms face financial constraints, equity and debt financing cost more and are less accessible (Edward et al., 2016), and consequently, firms rely more on internal funds to meet their investment needs. To make more internal funds available, managers may resort to corporate tax avoidance. The cash savings attributed to tax avoidance help lower the default risk of a financially constrained firm and thereby decrease its future crash risk. Consistent with this argument, we find evidence that stock price crash risk of financially constrained firms is lower when they avoid income taxes aggressively.

A firm’s credit rating reflects a credit rating agency’s opinion about the firm’s creditworthiness and its ability to meet financial obligations (Standard & Poor’s, 2009). A low credit rating implies a higher risk of default. So, financially constrained firms with low credit ratings should be more likely to default and to encounter stock price crashes, and we find evidence consistent with this argument.

Overall, our findings shed light on the stock price crash risk of financially constrained firms, and should have important implications for companies and their stakeholders, including investors, creditors, suppliers, and customers, who are concerned with the companies’ creditworthiness, viability, and prospects.


Ashbaugh-Skaife, H., Collins, D. W., LaFond, R., 2006. The effects of corporate governance on firms’ credit ratings. Journal of Accounting and Economics 42 (1-2): 203-243.

Benmelech, E., Kandel, E., and Veronesi, P. 2010. Stock-based compensation and CEO (dis)incentives. Quarterly Journal of Economics 125 (4): 1769-1820.

Campello, M., Graham, J. R., and Harvey, C. R., 2010. The real effects of financial constraints: Evidence from a financial crisis. Journal of Financial Economics 97(3): 470-487.

Chang, X., Chen, Y., and Zolotoy, L. 2017. Stock liquidity and stock price crash risk. Journal of Financial and Quantitative Analysis (forthcoming).

Edward, A., Schwab, C., and Shevlin, T., 2016. Financial constraints and cash tax savings. The Accounting Review 91 (3): 859-881.

He, G., 2015. The effect of CEO inside debt holdings on financial reporting quality. Review of Accounting Studies 20 (1): 501-536.

Hutton, A. P., Marcus, A. J., and Tehranian, H., 2009. Opaque financial reports, R2, and crash risk. Journal of Financial Economics 94(1): 67-86.

Jiang, L., Kim, J-B., and Pang, L., 2013. Insiders’ incentives for asymmetric disclosure and firm-specific information flows. Journal of Banking & Finance 37 (9): 3562-3576.

Jin, L., and Myers, S. C., 2006. R2 around the world: New theory and new tests. Journal of Financial Economics, 79 (2): 257-292.

Karamanou, I., and Vafeas, N., 2005. The association between corporate boards, audit committees, and management earnings forecasts: An empirical analysis. Journal of Accounting Research 43 (3): 453-486.

Kim, J-B., and Zhang, L., 2016. Accounting conservatism and stock price crash risk: Firm-level evidence. Contemporary Accounting Research 33 (1): 412-441.

Lamont, O., Polk, C., and Saaá-Requejo, J., 2001. Financial constraints and stock returns. Review of Financial Studies 14 (2): 529-554.

Standard & Poor’s, 2009. Standard & Poor’s Corporate Governance Scores: Criteria, Methodology and Definitions. McGraw-Hill Companies, Inc., New York.

Zhu, W., 2016. Accruals and price crashes. Review of Accounting Studies. 21(2): 349-499.

This post comes to us from Professor Guanming He and Helen Mengbing Ren, a PhD candidate, at the Warwick Business School, University of Warwick. It is based on their recent article, “Financial Constraints and Future Stock Price Crash Risk,” available here.