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Finance and Economics Discussion Series
Finance and Economics Discussion Series logo links to FEDS home page The Magnitude and Cyclical Behavior of Financial Market Frictions
Andrew T. Levin, Fabio M. Natalucci, and Egon Zakrajsek

Abstract: We quantify the cross-sectional and time-series behavior of the wedge between the cost of external and internal finance by estimating the structural parameters of a canonical debt-contracting model with informational frictions. For this purpose, we construct a new dataset that includes balance sheet information, measures of expected default risk, and credit spreads on publicly traded debt for about 900 U.S. firms over the period 1997Q1 to 2003Q3. Using nonlinear least squares, we obtain precise time-specific estimates of the bankruptcy cost parameter and consistently reject the null hypothesis of frictionless financial markets. For most of the firms in our sample, the estimated premium on external finance was very low during the expansionary period 1997-99, but rose sharply in 2000--especially for firms with higher ratios of debt to equity--and remained elevated until early 2003.

Keywords: External finance premium, bankruptcy costs, financial accelerator

Full paper (387 KB PDF)

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Last update: January 3, 2005