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Contract enforcement and firms’ financing

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Author Info
Cristina Arellano
Yan Bai
Jing Zhang

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Abstract

This paper studies how the degree of contract enforcement in a country influences firms’ financing decisions. We first document empirical facts on debt financing for two new firm-level datasets in the United Kingdom and Ecuador. In the United Kingdom, small firms borrow more relative to their assets than large firms, whereas in Ecuador small firms borrow less. We build a dynamic model of firms’ debt financing where debt is constrained by the likelihood of default, which varies across firms and economies with different degrees of enforcement. Because of their low firm values, small firms are mostly affected by abundance or scarcity of economy-wide loans generated by weak or strong contract enforcement. We calibrate our model to the datasets in the two countries and find that our mechanism can quantitatively account for the patterns observed in the data.

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Paper provided by Federal Reserve Bank of Minneapolis in its series Staff Report with number 392.

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Date of creation: 2007
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Handle: RePEc:fip:fedmsr:392

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  2. Jianjun Miao, 2005. "Optimal Capital Structure and Industry Dynamics," Journal of Finance, American Finance Association, vol. 60(6), pages 2621-2659, December. [Downloadable!] (restricted)
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  3. Eugene F. Fama, 2002. "Testing Trade-Off and Pecking Order Predictions About Dividends and Debt," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 15(1), pages 1-33, March.
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  4. Tor Jakob Klette and Samuel Kortum, 2004. "Innovating Firms and Aggregate Innovation," Journal of Political Economy, University of Chicago Press, vol. 112(5), pages 986-1018, October.
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  5. Quadrini, Vincenzo, 2004. "Investment and liquidation in renegotiation-proof contracts with moral hazard," Journal of Monetary Economics, Elsevier, vol. 51(4), pages 713-751, May. [Downloadable!] (restricted)
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  10. Esteban Rossi-Hansberg & Mark L. J. Wright, 2006. "Establishment size dynamics in the aggregate economy," Staff Report 382, Federal Reserve Bank of Minneapolis. [Downloadable!]
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  11. Erwan Quintin, 2001. "Limited enforcement and the organization of production," Center for Latin America Working Papers 0601, Federal Reserve Bank of Dallas. [Downloadable!]
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  15. John Y. Campbell & Jens Hilscher & Jan Szilagyi, 2006. "In Search of Distress Risk," NBER Working Papers 12362, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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