Feedback and Contagion Through Distressed Competition

Abstract

Firms tend to compete more aggressively in financial distress; this intensified competition, in turn, reduces profit margins, pushing themselves further into distress and adversely affecting their industry peers. To study such feedback and contagion effects, we incorporate strategic competition into a dynamic model with long-term defaultable debt, exploring various peer interactions like predation and price war. The feedback effect represents a novel source of financial distress costs associated with leverage, which helps explain the negative profitability-leverage relation across industries. Owing to the contagion effect, firms’ optimal leverage is often excessively high from an industry perspective, undermining the industry's financial stability.