Judicial Enforcement, Credit Frictions, and the Transmission of Bankruptcy through Firm Networks

We show that weak judicial enforcement and credit frictions jointly govern the transmission of corporate distress through trade-credit networks. Weak judicial enforcement increases the losses associated with defaulted trade credit, while credit frictions limit trade creditors' ability to absorb those losses. We exploit variation in court congestion generated by a nationwide reform that reassigned pending bankruptcy cases across courts. Trade creditors are more likely to go bankrupt when their trade debtor's case is handled by a congested court and when they face binding credit frictions. Bank relationships mitigate these frictions and insulate trade creditors from distress transmission. A counterfactual exercise shows that moving from the least tothe most efficient courts would reduce bankruptcy propagation by 40% and increase aggregate sales by 2%.