Testing the impact of liquidation speed on leverage using Indian data
Banerjee, Biswajit; Herrala, Risto (29.04.2024)
Numero
6/2024Julkaisija
Bank of Finland
2024
Julkaisun pysyvä osoite on
https://urn.fi/URN:NBN:fi-fe2024042923354Tiivistelmä
The paper investigates the influence of the speed of liquidation of insolvent firms on leverage. The theoretical model presented formalizes the intuitive view that an increase in liquidation speed is expected to decrease average leverage as highly leveraged firms exit. Analysis of Indian data, however, suggests that an increase in liquidation speed increases average leverage. This finding is linked to influential observations at the right tail of the leverage distribution. We propose an asset-weighted variant of the proposition that holds with empirical data.
Julkaisuhuomautus
NON-TECHNICAL SUMMARY
FOCUS
High corporate leverage may constrain investment, so liquidation of insolvent, highly leveraged firms may increase an economy’s overall growth potential. One instrument available to policymakers in overcoming this leverage constraint is altering the speed of liquidation of such firms. This paper investigates the influence of liquidation speed on firm leverage, described also as the liquidation speed channel.
CONTRIBUTION
The paper contributes a novel theory and empirical evidence about the liquidation speed channel. The theory, which builds on the incomplete contracting paradigm under moral hazard, says that leverage at the firm level is not sensitive to changes in liquidation speed. Instead, the liquidation speed channel is purely a sampling effect caused by the exit of insolvent, highly leveraged firms through liquidation. This finding leads to our proposition that the liquidation speed channel should always be negative. The theory provides estimators for testing the channel from balance-sheet da-ta. The estimators are applied to the case of India, which passed a new Insolvency and Bankruptcy Code in 2016 designed to increase liquidation speed.
FINDINGS
Analysis with unweighted data leads to the rejection of the proposition that an increase in liquidation speed should contribute to an increase in average leverage. This unexpected finding is linked to influential observations at the right tail of the leverage distribution. The theory holds for asset-weighted data.
FOCUS
High corporate leverage may constrain investment, so liquidation of insolvent, highly leveraged firms may increase an economy’s overall growth potential. One instrument available to policymakers in overcoming this leverage constraint is altering the speed of liquidation of such firms. This paper investigates the influence of liquidation speed on firm leverage, described also as the liquidation speed channel.
CONTRIBUTION
The paper contributes a novel theory and empirical evidence about the liquidation speed channel. The theory, which builds on the incomplete contracting paradigm under moral hazard, says that leverage at the firm level is not sensitive to changes in liquidation speed. Instead, the liquidation speed channel is purely a sampling effect caused by the exit of insolvent, highly leveraged firms through liquidation. This finding leads to our proposition that the liquidation speed channel should always be negative. The theory provides estimators for testing the channel from balance-sheet da-ta. The estimators are applied to the case of India, which passed a new Insolvency and Bankruptcy Code in 2016 designed to increase liquidation speed.
FINDINGS
Analysis with unweighted data leads to the rejection of the proposition that an increase in liquidation speed should contribute to an increase in average leverage. This unexpected finding is linked to influential observations at the right tail of the leverage distribution. The theory holds for asset-weighted data.