Collaborative Research: The Anatomy of Firm Exit: Theory and Facts

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Firm exit is a significant contributor to overall job destruction. In addition to the jobs lost, firm exit permanently destroys intangible capital, such as customer-firm relationships and brand reputation. Yet, the underlying drivers of firm exit remain relatively unexplored. This project will study which firm characteristics best predict firm exit, with a renewed focus on financial health. The goal is to determine which firms fail due to lack of long-run sustainability of the business activity (solvency) versus temporary restricted access to funding (illiquidity). The main hypothesis is that the latter is particularly salient in times of crises. Providing a theory that explains the type of market imperfection behind this pattern is crucial in order to design effective policy interventions. The proposed framework will allow researchers to assess whether policy responses to COVID-19 were adequate and suggest potential improvements in addressing future downturns.The first part of the project will study analytically the effect of financial distress on firm exit. The PIs propose a two-period model of firm dynamics with financial frictions. Firms are able to borrow funds from financial intermediaries using non-state-contingent debt to cover fixed operating costs. Firms may choose to default on their existing debt obligations. If they do so, financial intermediaries can take over and operate the firm, but at a fraction of its initial productivity. As a result of the default option, firms face an endogenous borrowing limit, giving rise to inefficient firm exit. While inefficient firm exit or the level of financial frictions cannot be directly measured in the data, the model provides a mapping between inefficient firm exit and the conditional covariance of a firm’s propensity to exit with its debt holdings. The second part of the project aims to shed light empirically on the key drivers of firm exit. Using firm-level data that includes detailed financial information, the PIs will characterize the sensitivity of firms’ propensity to exit to financial characteristics, and document how this sensitivity varies over the business cycle. The goal is two-fold. First, testing for the presence of inefficient firm exit in the lens of the analytical model. Second, providing moments to calibrate a quantitative version of the model. The third part of the project quantifies the degree of inefficient firm exit over the business cycle. The analysis will be based on an infinite-horizon model with aggregate fluctuations and endogenous firm entry and exit. The PIs will use the quantitative model to show how the welfare losses due to inefficient firm exit depend on the length and depth of recessions and on the magnitude of entry costs. Finally, the PIs will study the effectiveness of different policies aimed at alleviating firm exit inefficiencies.This award reflects NSF's statutory mission and has been deemed worthy of support through evaluation using the Foundation's intellectual merit and broader impacts review criteria.