Firm Exit and Financial Frictions

Gideon Bornstein and Laura Castillo-Martinez

No 21725, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: Governments often intervene to prevent firm closures during crises, fearing that financially constrained but viable firms may fail. We develop a firm dynamics model with incomplete financial markets and show how financial frictions generate excessive firm exit. A key statistic governing this dynamic inefficiency is the marginal propensity to exit with debt. Using confidential U.S. Census data, we estimate the relationship between debt and exit and use it to discipline the model. The calibrated model implies that eliminating financial frictions reduces firm exit from 9.3\% to 5.0\% and generates welfare gains of 3.6\% in consumption-equivalent terms. We show that the welfare costs of financial frictions rise sharply during financial crises but change little during standard productivity recessions. Finally, we compare government-guaranteed loans and grants, quantifying the trade-off between fiscal cost and effectiveness in preventing excessive exit.

Date: 2026-07
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