Bankruptcy costs, idiosyncratic risk, and long-run growth

Abstract This paper analyzes how idiosyncratic risk, measured by the variance of firm-level idiosyncratic shocks, affects long-run growth when bankruptcy costs are present. These costs are incurred by creditors during the bankruptcy procedure of failing firms. In an endogenous growth model with bankruptcy costs where firms privately observe the outcome of idiosyncratic shocks, an increase in idiosyncratic risk reduces long-run growth. This happens because, when bankruptcy costs are present, higher idiosyncratic risk enlarges the wedge between the rental rate of capital and its marginal product, thereby slowing down capital accumulation. This growth-reducing effect of idiosyncratic risk is stronger when bankruptcy costs are higher. Empirical support for these propositions is provided in a growth regression that exploits cross-country variations in the dispersion of firms’ real sales growth as a proxy for idiosyncratic risk along with recovery rates as a measure that proxies the inverse of bankruptcy costs.