Feedback and Contagion Through Distressed Competition

Abstract

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.

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