Risk-taking with Financing Constraints

We study the impact of liquidity constraints on firms' risk-taking that depends on leveraged returns and volatility. We show that relaxing financing constraints may or may not encourage risk-taking. Following an interest-rate cut, fewer firms are willing to take risks if their leverage is low; more firms prefer to take risks if their leverage is high. The result highlights that liquidity policies can generate a non-linear effect on risk-taking and social welfare. Therefore, we can observe a non-monotone relationship between the interest rate and firm-return volatility in the aggregate. A cut in interest rate may not encourage firms to implement risky but socially desirable projects.

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