Feedback and Contagion Through Distressed Competition
62 Pages Posted: 16 Jan 2023 Last revised: 30 Jan 2023
There are 2 versions of this paper
Feedback and Contagion through Distressed Competition
Date Written: January 2023
Firms tend to compete more aggressively in financial distress; the intensified competition in turn reduces profit margins, pushing themselves further into distress and adversely affecting other firms. To study such feedback and contagion effects, we incorporate strategic competition into a dynamic model with long-term defaultable debt, which generates various peer interactions like predation and self-defense. The feedback effect imposes an additional source of financial distress costs incurred for raising leverage, which helps explain the negative profitability-leverage relation across industries. Owing to the contagion effect, in a decentralized equilibrium, leverage is excessively high from an industry perspective, compromising industry's financial stability.
Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.
Suggested Citation: Suggested Citation