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 December 2017
NBER Program(s):Corporate Finance, Economic Fluctuations and Growth, International Finance and Macroeconomics, Monetary Economics

Why are downturns following episodes of high valuations of firms so severe and long? Why do firms take on high debt when they anticipate high valuations, and underperform subsequently? In this paper, we propose a theory of financing cycles where the control rights to enforce claims in an asset price boom (rights to sell assets) differ from the control rights used in more normal times (rights over cash flows that we term “pledgeability”). Firm management’s limited incentive to enhance pledgeability in an asset price boom can have long-drawn adverse effects in a downturn, which may not be resolved by debt renegotiation. This can also explain why involuntary asset turnover and asset misallocation to outsiders are high in a downturn, as well as why industry productivity falls. The paper highlights an adverse consequence of high anticipated liquidity, working through leverage, on the economy’s access to finance and productivity when that liquidity fails to materialize. It also suggests that higher anticipated liquidity can tighten credit constraints, instead of alleviating them.

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Document Object Identifier (DOI): 10.3386/w23055

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