NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH
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Pledgeability, Industry Liquidity, and Financing Cycles

Douglas W. Diamond, Yunzhi Hu, Raghuram G. Rajan

NBER Working Paper No. 23055
Issued in January 2017, Revised in August 2018
NBER Program(s):Corporate Finance, Economic Fluctuations and Growth, International Finance and Macroeconomics, Monetary Economics

Why are downturns following high valuations of firms long and severe? Why do firms choose high debt when they anticipate high valuations, and underperform subsequently? We propose a theory of financing cycles where the importance of creditors’ control rights over cash flows (“pledgeability”) varies with industry liquidity. Firms take on more debt when they anticipate higher future industry liquidity. However, both high anticipated liquidity and the resulting high debt limit their incentives to enhance pledgeability. This has prolonged adverse effects in a downturn. Higher anticipated liquidity can, in fact, reduce a firm’s current access to finance.

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Document Object Identifier (DOI): 10.3386/w23055

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