Working Paper: NBER ID: w15058
Authors: Stavros Panageas
Abstract: A firm's termination leads to bankruptcy costs. This may create an incentive for outside stakeholders or the firm's debtholders to bail out the firm as bankruptcy looms. Because of this implicit guarantee, firm shareholders have an incentive to increase volatility in order to exploit the implicit protection. However, if they increase volatility too much they may induce the guarantee-extending parties to "walk away". I derive the optimal risk management rule in such a framework and show that it allows high volatility choices, while net worth is high. However, risk limits tighten abruptly when the firm's net worth declines below an endogenously determined threshold. Hence, the model reproduces the qualitative features of existing risk management rules, and can account for phenomena such as "flight to quality".
Keywords: Bailouts; Risk Management; Financial Crises
JEL Codes: G01; G32; G33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| bailouts (H81) | risk management behavior (G41) |
| firm's net worth (G32) | risk management choices (G11) |
| implicit guarantee from stakeholders (D86) | volatility of projects (G17) |
| volatility of projects (G17) | shareholder value (G34) |
| firm's net worth (G32) | volatility of projects (G17) |
| volatility of projects (G17) | risk of bankruptcy (G33) |