Abstract
Several economic theories suggest that vulnerable financial conditions of the corporate sector can trigger or worsen an economy-wide recession. This paper proposes a measure of corporate vulnerability, the Corporate Vulnerability Index (CVI) and analyses whether it can explain the probability and severity of recessions.The CVI is constructed as the default probability for the entire corporate sector, using the structural model of corporate debt by Anderson, Sundaresan, and Tychon (1996). We find that the CVI is a significant predictor of the probability of a recession 4 to 6 quarters ahead, even controlling for other leading indicators. The probit model using the CVI outperforms traditional specifications in predicting recessions, including the recession of 1990-1991 - a common miss by the other models. In order to assess whether the CVI is related to the severity of a recession, Severity of Recession Indices are proposed and constructed, ranking recessions both in terms of the cumulative output loss and recession duration. The ordered probit estimations indicate that an increase in the CVI is associated with an increase in the probability of a more severe and lengthy recession 3 to 6 quarters ahead.