Credit chains and the propagation of financial distress

Frédéric Boissay

No 573, Working Paper Series from European Central Bank

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. JEL Classification: E32, G29, G33

Keywords: business fluctuations; Financial contagion; trade credit (search for similar items in EconPapers)
Date: 2006-01
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Citations: View citations in EconPapers (43)

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Persistent link: https://EconPapers.repec.org/RePEc:ecb:ecbwps:2006573

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