Implications of Default Recovery Rates for Aggregate Fluctuations

Giacomo Candian and Mikhail Dmitriev
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Mikhail Dmitriev: Florida State University
Authors registered in the RePEc Author Service: Mikhail Dmitriev and Mikhail Dmitriev

No 1185, 2019 Meeting Papers from Society for Economic Dynamics

Abstract: We document that default recovery rates in the United States are highly volatile and strongly pro-cyclical. These facts are hard to reconcile with the existing financial friction literature. Indeed, models with limited enforceability a la Kiyotaki and Moore (1997) do not have defaults and recovery rates, while agency costs models following Bernanke, Gertler, and Gilchrist (1999) underestimate the volatility of recovery rates by one order of magnitude. We extend the standard agency costs model allowing liquidation costs for creditors to depend on the tightness of the market for physical capital. Creditors do not have expertise in selling entrepreneurial assets, but when buyers are plentiful, this disadvantage is minimal. Instead when sellers are abundant, the disadvantage of being an outsider is higher. Following a negative shock, entrepreneurs sell capital and liquidation costs for creditors increase. Creditors cut lending and cause entrepreneurs to sell more capital. This liquidity channel works independently from standard balance sheet effects and amplifies the impact of financial shocks on output by up to 50 percent.

Date: 2019
New Economics Papers: this item is included in nep-ban, nep-dge, nep-ent, nep-fdg, nep-mac and nep-rmg
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