In the mind of a stressed borrower

A game of signals and asymmetric information

When a firm faces stress, the story turns on whether it is insolvent or merely illiquid. In this article, we put ourselves in the shoes of a firm facing difficulties in debt servicing. Liquidity stress, with a weak financial system, can potentially generate insolvency.

When a firm faces stress, the heart of the question is: Illiquidity versus insolvency. Illiquid is a firm that has payments to make, but lacks cash to make them. This could happen because the firm has good assets which are illiquid. Insolvent is a firm which is not able to pay off the liabilities even if all