Firm behaviour under the threat of liquidation

Debt Matters: The Firms Optimization Problem With Financial Distress

“…In particular, firms will produce less than the optimal output when financial distress looms. Milne and Robertson (1996) advance an argument somewhat similar to that of Greenwald and Stiglitz. They assume an exogenous threat of liquidation if cash in hand falls below a specified level (representing credit market imperfections) and that the firm maximizes shareholder value defined as the value of the stream of dividend payments.…”

“…Assume that a firm will default on its debt if it does not make a positive profit in the present period (we will dispense with the subscript for the period t=0), and if it defaults the cost of resolving the distress will be so great that the firm will do better to shut down, losing the entire value  (one can think of this as a case where credit law renders it extremely costly to restructure debts) 11 . In this very stylized case the firm's value as function of present period profit will be:…”

Bank capital, interbank contagion, and bailout policy

“…These obtain because, post-crisis, the only decision of the bank is to pay or retain dividends and to continue in operation until, eventually, capital falls to the minimum regulatory required level Ĉ and the bank must close. This is a standard problem of optimal balance sheet management, previously solved by Milne and Robertson (1996), Radner and Shepp (1996) …”

“…Then we extend the analysis 2 This strand of literature posits that banks treat their capital holding strategy as an inventory decision that allows them to be forward-looking by increasing their capital levels as necessary or adjusting their asset portfolios in response to any future breach of regulatory capital requirements. The buffer stock model of bank capital was first proposed by Baglioni and Cherubini (1994), later developed by Milne and Robertson (1996), Milne and Whalley (2001), Milne (2004), and in discrete time by Calem and Rob (1996). Peura and Keppo (2006) extend the continuous-time framework to take account of delays in raising capital.…”

“…Peura and Keppo (2006) extend the continuous-time framework to take account of delays in raising capital. Milne and Robertson (1996) state that banks maintain extra capital in excess of minimum regulatory requirements in order to reduce the potential future costs of illiquidity and recapitalization. Milne (2002) further examines the implications of bank capital regulation as an incentive mechanism for portfolio choice.…”