Pledgeability, Industry Liquidity, and Financing Cycles

52 Pages Posted: 17 Jan 2017 Last revised: 31 Dec 2021

See all articles by Douglas W. Diamond

Douglas W. Diamond

University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER)

Yunzhi Hu

University of North Carolina (UNC) at Chapel Hill - Finance Area

Raghuram G. Rajan

University of Chicago - Booth School of Business; International Monetary Fund (IMF); National Bureau of Economic Research (NBER)

Date Written: January 2017

Abstract

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. The market allows firms take on more debt when they anticipate higher future 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. Because these effects are hard to contract upon, higher anticipated liquidity can also reduce a firm’s current access to finance.

Suggested Citation

Diamond, Douglas W. and Hu, Yunzhi and Rajan, Raghuram G., Pledgeability, Industry Liquidity, and Financing Cycles (January 2017). NBER Working Paper No. w23055, Available at SSRN: https://ssrn.com/abstract=2900061

Douglas W. Diamond (Contact Author)

University of Chicago - Booth School of Business ( email )

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National Bureau of Economic Research (NBER)

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Yunzhi Hu

University of North Carolina (UNC) at Chapel Hill - Finance Area ( email )

Kenan-Flagler Business School
Chapel Hill, NC 27599-3490
United States

Raghuram G. Rajan

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
773-702-4437 (Phone)
773-702-0458 (Fax)

International Monetary Fund (IMF) ( email )

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National Bureau of Economic Research (NBER)

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