Pierre Olivier Gourinchas, Şebnem Kalemli-Özcan, Veronika Penciakova, and Nick Sander
Working Paper 2020-21a
December 2020 (Revised August 2023)

Full text Adobe PDF file format

Abstract: We study the effects of financial frictions on firm exit when firms face large liquidity shocks. We develop a simple model of firm cost-minimization that introduces a financial friction that limits firms’ borrowing capacity to smooth temporary shocks to liquidity. In this framework, firm exit arises from the interaction between this financial friction and fluctuations in cash flow due to aggregate and sectoral changes in demand conditions, as well as more traditional shocks to productivity. To evaluate the implications of our model, we use firm level data on small and medium-sized enterprises (SMEs) in 11 European countries. We confirm that our framework is consistent with official failure rates in 2017–19, a period characterized by standard business cycle fluctuations in demand. To capture a large liquidity shock, we apply our framework to the COVID-19 crisis. We find that, absent government support, SME failure rates would have increased by 6.01 percentage points, putting 3.1 percent of employment at risk. Our results are consistent with the premise that financial frictions lead to inefficient exit as, without government support, the firms failing due to COVID have similar productivity and past growth to firms that survive COVID.

JEL classification: D2, E62, E65, G33, H81, L25

Key words: COVID-19, business failures, liquidity, small business


An earlier version of this paper circulated under the title "COVID-19 and SME Failures." The authors thank Ryan Decker, Philippe Martin, Brent Neiman, Xavier Ragot, David Sraer, David Thesmar, Jianlan Wang, colleagues at the International Monetary Fund, seminar participants at the Bank for International Settlements, the Organisation for Economic Co-Operation and Development, Banco Central de Chile, the San Francisco Fed, the 2019 "Conference on the Financial Consequences of the COVID-19 Pandemic" organized by the Journal of Finance and the Fama-Miller Center (Chicago Booth), the 2020 Federal Reserve System Macroeconomics Conference, and the ASSA 2021 meetings for useful comments. The views expressed here are those of the authors and do not necessarily reflect the views of the Federal Reserve System, the Federal Reserve Board of Governors, the Bank of Canada, or their staff.

Please address questions regarding content to Pierre Olivier Gourinchas; Şebnem Kalemli-Özcan; Veronika Penciakova; or Nick Sander.

To receive e-mail notifications about new papers, subscribe. Under "Publications" select "Working Papers."