"Birds of a Feather" Fail Together: Exploring the Nature of Dependency in SME Defaults

This article studies the effects of incorporating the interdependence among London small business defaults into a risk analysis framework using the data just before the financial crisis. We propose an extension from standard scoring models to take into account the spatial dimensions and the demographic characteristics of small and medium-sized enterprises (SMEs), such as legal form, industry sector, and number of employees. We estimate spatial probit models using different distance matrices based only on the spatial location or on an interaction between spatial locations and demographic characteristics. We find that the interdependence or contagion component defined on spatial and demographic characteristics is significant and that it improves the ability to predict defaults of non-start-ups in London. Furthermore, including contagion effects among SMEs alters the parameter estimates of risk determinants. The approach can be extended to other risk analysis applications where spatial risk may incorporate correlation based on other aspects.