Bargaining Power, Business Cycle and Levered Equity Risk

Bargaining power allows equity holders to recover a fraction of residual assets in bankruptcy, therefore reducing their exposure to default risk. We develop an agency-based model and provide the first evidence via structural estimation that equity holders could extract about 50\% of the liquidation surplus from the residual assets. Using a counterfactual experiment, we further demonstrate that bargaining power significantly reduces equity risk, as proxied by stock-cash flow sensitivity. The percentage reduction is 15% during expansions and 36% during recessions for highly leveraged firms, and is 10% during expansions and 26% during recessions for firms with a high book-to-market ratio.