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Credit chains and the propagation of financial distress

  • Boissay, Frédéric

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

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Paper provided by European Central Bank in its series Working Paper Series with number 0573.

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Date of creation: Jan 2006
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Handle: RePEc:ecb:ecbwps:20060573
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  1. Mitchell A. Petersen & Raghuram G. Rajan, 1996. "Trade Credit: Theories and Evidence," NBER Working Papers 5602, National Bureau of Economic Research, Inc.
  2. Lee, Yul W. & Stowe, John D., 1993. "Product Risk, Asymmetric Information, and Trade Credit," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 28(02), pages 285-300, June.
  3. von Kalckreuth, Ulf & Hernando, Ignacio & Generale, Andrea & Chatelain, Jean Bernard & Vermeulen, Philip, 2001. "Firm Investment and Monetary Policy Transmission in the Euro Area," Discussion Paper Series 1: Economic Studies 2001,20, Deutsche Bundesbank, Research Centre.
  4. Mojon, Benoît & Kashyap, Anil K. & Angeloni, Ignazio & Terlizzese, Daniele, 2002. "Monetary Transmission in the Euro Area : Where Do We Stand?," Working Paper Series 0114, European Central Bank.
  5. Burkart, Mike & Ellingsen, Tore, 2002. "In-Kind Finance," CEPR Discussion Papers 3536, C.E.P.R. Discussion Papers.
  6. Biais, Bruno & Gollier, Christian, 1997. "Trade Credit and Credit Rationing," Review of Financial Studies, Society for Financial Studies, vol. 10(4), pages 903-37.
  7. Vincente Cuñat, 2000. "Trade Credit: Suppliers as Debt Collectors and Insurance Providers," FMG Discussion Papers dp365, Financial Markets Group.
  8. Brennan, Michael J & Maksimovic, Vojislav & Zechner, Josef, 1988. " Vendor Financing," Journal of Finance, American Finance Association, vol. 43(5), pages 1127-41, December.
  9. Emery, Gary W., 1987. "An Optimal Financial Response to Variable Demand," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 22(02), pages 209-225, June.
  10. Franklin Allen & Douglas Gale, 1998. "Financial Contagion Journal of Political Economy," Center for Financial Institutions Working Papers 98-31, Wharton School Center for Financial Institutions, University of Pennsylvania.
  11. Ferris, J Stephen, 1981. "A Transactions Theory of Trade Credit Use," The Quarterly Journal of Economics, MIT Press, vol. 96(2), pages 243-70, May.
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