Pledgeability, Industry Liquidity, and Financing Cycles

Douglas Diamond, Yunzhi Hu and Raghuram Rajan

No 23055, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: Why do firms choose high debt when they anticipate high valuations, and underperform subsequently? We propose a theory of financing cycles where the importance of creditors’ control rights over cash flows (“pledgeability”) varies with industry liquidity. The market allows firms take on more debt when they anticipate higher future liquidity. However, both high anticipated liquidity and the resulting high debt limit their incentives to enhance pledgeability. This has prolonged adverse effects in a downturn. Because these effects are hard to contract upon, higher anticipated liquidity can also reduce a firm’s current access to finance.

JEL-codes: E00 E02 E59 G20 G21 G31 G33 (search for similar items in EconPapers)
Date: 2017-01
New Economics Papers: this item is included in nep-mac and nep-mic
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Citations: View citations in EconPapers (8)

Published as DOUGLAS W. DIAMOND & YUNZHI HU & RAGHURAM G. RAJAN, 2020. "Pledgeability, Industry Liquidity, and Financing Cycles," The Journal of Finance, vol 75(1), pages 419-461.

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