Endogenous Value and Financial Fragility

Abstract

We construct a model of valuation to assess the financial fragility of a set of firms in a closed economy. A firm is identified with a possibly infinite random sequence of benefits. Firms with negative benefits in a given period are said to be in distress and need liquidity to refinance their projects. Those liquidities must be obtained from firms with positive benefits (which represent excess liquidities). Distressed projects are refinanced to the extent that their need for liquidity does not exceed their endogenous continuation value. This value is, in turn, affected by current and future refinancing possibilities. We provide a recursive procedure to compute this value when there is an aggregate liquidity constraint. We compare the allocation under a centralized coalition of firms with that of a decentralized competitive liquidity market. We show that the competitive market is more fragile because it does not value the possibility that a currently distressed firm could become a provider of liquidity some period in the future. That is, the market value of a firm candiverge from its social value due to externalities involving the ability of that firm to refinance other distressed firms in the future.Financial fragility, Liquidity constraints, value, bankruptcy