Credit Chains and the Propagation of Financial Distress

34 Pages Posted: 17 Jan 2006

See all articles by Frédéric Boissay

Frédéric Boissay

Bank for International Settlements (BIS)

Date Written: January 2006

Abstract

The purpose of this paper is to analyze how shocks propagate through a network of firms that borrow from, and lend to, each other in a trade credit chain, and to quantify the effects of financial contagion across firms. I develop a theoretical model of financial contagion, in which the default of one firm may cause a chain reaction such that its creditors also get into financial difficulties, even though they are sound in the first place. I calibrate and simulate the model using US annual data over the period 1986-2004. At the microeconomic level, I find that, when customers of a sound firm are financially distressed, then this firm gets into financial difficulties with probability that ranges from 4.1% to 12.8% (depending on the business cycle and the underlying economic scenario). Looking at the macroeconomic level, I find that defaults on trade debts lower aggregate GDP by at least 0.4%. During the second half of the 90's, these deadweight losses doubled and reached a high of 0.9% to 2.3% of GDP (depending on the underlying economic scenario) before the recession of 2001. The results of the simulations also suggest that financial contagion across businesses had been 25% higher during the last recession than during the recession of the early 90's.

Keywords: Financial contagion, trade credit, business fluctuations

JEL Classification: E32, G29, G33

Suggested Citation

Boissay, Frédéric, Credit Chains and the Propagation of Financial Distress (January 2006). ECB Working Paper No. 573. Available at SSRN: https://ssrn.com/abstract=872543

Frédéric Boissay (Contact Author)

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

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