The Value of Relational Contracts in Outsourcing: Evidence from the 2008 shock to the US Airline Industry*
Ricard Gil Myongjin Kim Giorgio Zanarone Queen’s University University of Oklahoma CUNEF [email protected] [email protected] [email protected]
December 2018
Abstract
We study the importance of relationships, relative to formal contracts, as a tool to govern transactions across firm boundaries. Guided by a simple model, we show that the likelihood that a major airline continues to outsource a route to a regional partner after the 2008 crisis increases in the present discounted value of their relationship, and more so on routes characterized by strong contracting frictions. We also show that major and regional airlines involved in higher-value relationships are more likely to help each other under adverse weather by exchanging landing slots. Our evidence suggests that even in economies with strong institutions and in industries governed by sophisticated technology and standardized formal contracts, informal relationships play a central role in promoting cooperation and performance.
Keywords: Relational contracting, adaptation, outsourcing, airlines JEL codes: L14, L22, L24, L93
* We thank Ricardo Alonso, Benito Arruñada, Dan Barron, Alessandro Bonatti, Giacomo Calzolari, Marco Casari, Decio Coviello, Matthias Dewatripont, Mikhail Drugov, John de Figueiredo, William Fuchs, Luis Garicano, Bob Gibbons, María Guadalupe, Hideshi Itoh, Mara Lederman, Alex Lin, Rocco Macchiavello, Bentley MacLeod, Mark Moran, Ameet Morjaria, Joanne Oxley, Mike Powell, Rachelle Sampson, Juan Santalo, Giancarlo Spagnolo, Jill Sparrow, Pablo Spiller, Catherine Thomas, Nick Vikander, Steve Tadelis, Patrick Warren, and audiences at Aarhus University, Pompeu Fabra University, Hitotsubashi University, EIEF, INSEAD, Queen’s University, Universidad del Pais Vasco, CEMFI, Universitat de Valencia, University of Maryland Smith School of Business, Bologna University, INSPER, HEC Montreal, ECARES, Rotman Toronto, IE Business School, the fifth CEPR Workshop on Incentives Management and Organization at LMU Munich, the second Workshop on Relational Contracts at CUNEF, the third Berkeley-Paris Organizational Economics Workshop, the tenth Organizational Economics Workshop at the University of Sydney, the NBER Organizational Economics Workshop, the 2017 Empirical Management Conference, and SIOE, the Winter Econometric Society Meetings and the European Economic Association Meetings, among others, for useful comments. This study received financial support from the Spanish Ministry of the Economy, Industry and Competitiveness through grant ECO2017-85763-R. The usual disclaimer applies.
1. Introduction
A large share of production in modern economies occurs across organizational boundaries – that is, via transactions between firms and their independent suppliers, distributors, and strategic partners.1 It is well known that when formal contracts are incomplete, and therefore vulnerable to holdup and opportunism2, firms may rely on self- enforcing “relational” contracts to govern these transactions (e.g., Klein, 2000; Baker et al., 2002).3
Understanding how much relational ties increase cooperation, relative to purely formal contracts, is important for productivity, growth and policy in developed economies, where both governance mechanisms are potentially available. For instance, manufacturers should procure from few trusted suppliers, “Toyota-style”, only if the resulting increase in reliability offsets the cost savings of competitive arm’s-length procurement (Board, 2011). Analogously, in the policy realm, a government should consider liberalizing exclusive dealing to promote tight relationships between firms and distributors only if the resulting improvements in customer service justified the loss of competition.
Unfortunately, because most empirical research on relational contracting analyzes settings in which the alternative of formal contracting is ruled out “by design”, there is remarkably little evidence that can be used to inform these choices. 4 For instance, McMillan and Woodruff (1999) show that relationships and reputations facilitate trade credit in Vietnam, where courts are dysfunctional. Similarly, Macchiavello and Morjaria (2015) show that contracts between Kenyan rose exporters and foreign buyers,
1 Lafontaine and Slade (2007) report that 50% of economic transactions in the United States occur in markets. More recently, Alfaro et al. (2016) estimate that in every WTO country the average manufacturing firm purchases at least 90% of its inputs (excluding capital and labor) from external suppliers. 2 On the transaction costs of interfirm contracting see, for instance, Coase (1937), Williamson (1971), and more recently, Hart and Moore (2008). 3 Reviews of the theoretical literature on relational contracting in economics are offered by MacLeod (2007), Malcomson (2013), and Gil and Zanarone (2017). Outside economics, the interplay between formal contracts and relational ties has been also emphasized in the legal literature (e.g., Macauley, 1963; MacNeil, 1978) and in the sociology and management studies literatures (e.g., Uzzi, 1997; Dyer and Singh, 1998; Poppo and Zenger, 2002; Ryall and Sampson, 2009). 4 See Cao and Lumineau (2015) for a recent review of qualitative empirical studies in the sociology and management literatures. 2
unenforceable in court due to their international nature and to flowers’ perishability, are constrained by relationships and reputations. While strong and convincing, the results from these studies cannot be used to predict how much relationships affect cooperation when they coexist with sophisticated formal contracts, as in supply chains, distribution networks and strategic alliances in developed economies.
Our paper importantly contributes to fill this gap. We study a large and strategically crucial industry – air transportation in the United States – in which outsourcing relationships between major and regional airlines are pervasive and regulated by highly detailed and standardized formal contracts. Using a simple relational contracting model, we develop a strategy to measure the present discounted value of these outsourcing relationships. We show robust evidence that partnerships that have high relationship value (and hence can enforce relational contracts) perform significantly better than those that have low relationship value (and must therefore rely more on the letter of the formal contract). In particular, we show that relationships with higher value: (1) are more likely to survive the 2008 industry-wide shock induced by the financial crisis, and (2) cooperate in more slot exchanges under adverse weather.
Three features of the U.S. airline industry are especially beneficial for our purposes of this study. First, despite the existence of reliable courts, transaction complexity limits the effectiveness of formal contracts as adverse weather requires rapid adaptation of flight schedules that is hard to specify ex ante or negotiate ex post (Forbes and Lederman, 2007). This creates a potential demand for relational contracts. Second, the value added of relational ties is potentially high as insufficient adaptation – and the ensuing flight delays and cancellations – severely affect airlines’ profits and consumer welfare. A study commissioned by the Federal Aviation Administration (FAA hereafter) and produced by NEXTOR (2010) finds that delays cost $8.3 billion a year to the airline industry (due to increased spending on crews, fuel and maintenance), and nearly $16.7 billion to passengers. The same study also estimates that delays generate an additional $7.9 billion in indirect costs (foregone travel plus GDP reductions due to increased cost of doing
3
business).5 Third and finally, the vertical structure of the airline industry – long-term relationships between major and regional airlines characterized by contractual incompleteness, repeated interactions and the importance of adaptation and flexibility – resembles other industries (e.g., Lerner and Merges, 1998, on biotechnology alliances; Arruñada et al., 2001, and Zanarone, 2013, on car distribution networks; Corts and Singh, 2004, and Kellogg, 2011, on oil drilling outsourcing). Therefore, our results are also relevant and informative on the role and importance of relational contracting for cooperation in those contexts.
1.1. Overview of the empirical strategy and results
We begin our study by documenting that adaptation occurs within major-regional partnerships rather than in arm’s-length transactions. We explore detailed data on landing slot exchanges following a slot rationing jointly called by the FAA and the NYC airport authorities. We show that major airlines almost exclusively adapt to the rationing by exchanging slots with regional airlines in their network, despite the availability of slots from airlines outside the network. In particular, the majors identify all slots that need to be moved to guarantee optimal adaptation of flight schedules following the slot rationing, and rapidly get their regional partners to exchange slots both with the major and with each other as needed.
Motivated by this evidence, in the second part of our study we systematically investigate how differences in the strength of relational ties affect the stability and performance of otherwise similar outsourcing networks. Guided by a simple theoretical model, we show that when a major airline outsources a given route to a regional partner before the 2008 shock, it is more likely to continue outsourcing that route to the same partner after the shock the higher the value of their relationship. We also show that the pre-shock present discounted value (PDV hereafter) of major-regional relationships matters more for the survival of “marginal” routes – that is, routes that the major barely outsourced before the shock because their high adaptation cost made relational contracting with the regional hard to sustain. Finally, we provide direct evidence that the
5 See full article here, https://centreforaviation.com/analysis/reports/the-cost-of-delays-late-flights-cost-us- economy-usd33-billion-39215. 4
ability of major and regional airlines to solve adaptation problems depends on the value of their relationships: using our NYC slot exchange data for February 2016, we show that in a given day and airport, partnerships with higher PDV exchange more landing slots during FAA slot rationing periods known as Ground Delay Programs. Our results are robust to the inclusion of major and regional airline fixed effects, route fixed effects, as well as controls for past interactions. When we study the effect of PDV on the survival of marginal routes, our analysis even includes relationship fixed effects as we aim to identify marginal routes within each major-regional network Therefore, the results are not driven by differences in firm-specific capabilities, relationship-specific capabilities or relationship-specific learning.
An important contribution of our study is the measurement of the PDV of major- regional partnerships. To measure PDV, we rely on the theoretical result that for a relational contract to be self-enforcing, the PDV of the relationship must be at least as large as the maximum gains from reneging (Macchiavello and Morjaria, 2015). In our model, the maximum reneging temptation is given by a regional airline’s cost of adapting flight schedules in the worst-case scenario where bad weather strikes all routes in the network. We use bad weather conditions on a route as an exogenous proxy for the regional airline’s adaptation costs on that route (Forbes and Lederman, 2009), and then construct a proxy for the maximum reneging temptation in a major-regional network by aggregating route-level weather conditions across all routes in that network. We use our proxy variable as a lower bound for the network’s PDV.
1.2. Relation to the literature
Early economic studies of the interplay between relational and formal contracting have shown that relationship strength, proxied by the extent of past interactions, decreases the use of formal incentive provisions in outsourcing agreements (Corts and Singh, 2004, on oil drilling; Kalnins and Mayer, 2004, on IT outsourcing).6 Most recently and closer to the research question in our paper, Macchiavello and Miquel-Florensa
6 Other studies in the management literature present evidence consistent with formal and informal contracts being used as complementary, rather than substitute tools (Poppo and Zenger, 2002; Ryall and Sampson, 2009). 5
(2017) have adopted a similar approach to estimate the effect of relationships on performance, rather than on contract design. In a study of Costa Rican coffee chains, they show that when good weather unexpectedly increases production, mills allocate the additional coffee to vertically integrated buyers and independent buyers that have traded repeatedly with the mill, but not to buyers without prior interactions with the mill.
When firms engage in relationship-specific learning over time, measuring PDV through past interactions may mislead the assessment of the importance of relational contracting. A few recent papers, including ours, strive to distinguish relational contracting from relationship-specific learning and accumulated reputation by developing measures of relationship strength that do not rely on past interactions.7 Gil and Marion (2013) analyze longitudinal data on subcontracting in California highway procurement. They show that controlling for past interactions, when more future project auctions are announced by local authorities – and hence contractors and their subcontractors face a longer time horizon in their partnerships – contractors post lower bids in current auctions. Barron et al. (2017) study contracts between a movie exhibitor and multiple distributors and show that the exhibitor is more likely to keep high-risk movies on screen when the PDV of its future relationship with the distributor is higher. Like us, they measure PDV through the distributor’s reneging temptation (proxied by the maximum discount ever granted to the exhibitor). At the same time, our approach differs from theirs in that we exploit an exogenous shock to the value of relational contracts in outsourcing partnerships – namely, the 2008 financial crisis.8
Our paper also relates to the broader empirical literature on interfirm relationships in transaction cost economics and industrial organization. Classic contributions to this literature are Masten and Crocker (1986) and Crocker and Reynolds (1993) on price adjustment provisions in procurement; Joskow (1987) on contract duration in coal mining; and Lafontaine (1992) on revenue sharing provisions in franchising. More recent work analyzes the allocation of control rights in distribution agreements (Arruñada et al., 2001; Zanarone, 2009, 2013) and strategic alliances (Lerner and Merges, 1998).
7 On relationship-specific learning in interfirm collaborations, see for all Kellogg (2011). 8 A broader discussion of the empirical papers that relate to informal and relational contracting, both between firms and within, and of the empirical challenges faced by those studies, can be found in Gil and Zanarone (2017, 2018). 6
Lafontaine and Slade (1997, 2013) offer extensive reviews of the literature on interfirm contracting. All of these works focus on how moral hazard and other transaction costs shape formal contracts, and hence, unlike our paper, do not provide evidence on relational contracting mechanisms.
The rest of the paper is organized as follows. Section 2 describes the contractual relationships between US major and regional airlines and presents qualitative data and descriptive evidence on landing slot exchanges that is consistent with the importance of relational contracting. Section 3 develops a simple theoretical model that delivers testable predictions on how the value of relationships affects cooperation and performance in major-regional partnerships. Section 4 describes the data we use in our main exercise on the survival of route outsourcing decisions around the 2008 shock. Section 5 presents the empirical methodology and the results. Section 6 discusses robustness checks. Section 7 concludes.
2. Contracting and governance in the U.S. airline industry
2.1. The importance of outsourcing
Major airlines fly routes using either their own planes or those of regional airlines. Regional airlines operate small planes and may be independent or owned by a major airline. In our sample period, the relationships between major airlines and independent regional partners are governed by “capacity purchase agreements” (Forbes and Lederman, 2007). Under such agreements, the regional autonomously operates the assigned flights with its own planes and crews, while the major sets flight schedules, sells tickets, and buys the fuel. The major is residual claimant of all revenues, while the regional receives a “rental” fee per flight from the major and is residual claimant of plane maintenance and labor costs.
Outsourcing to independent regionals allows major airlines to save on labor costs because the regionals are not unionized, and their pilots and crew earn significantly lower wages than those at the major airlines. As a result, outsourcing is widespread in the industry. For instance, in a recent Wall Street Journal article, Carey (2016) reports that
7
regional carriers operated 44% of passenger flights in 2015 and were the sole providers of commercial flights with scheduled service to 65% of US airports. Figure 1 below also illustrates the increasing importance of outsourcing over the last two decades.
Figure 1. Major-Regional Relationships between 1993 and 2013.
2.2. The insufficiency of formal contracts
Major airlines invest considerable efforts into designing flight schedules that allow passengers to reach their destinations on time. However, exogenous disruptions occasionally make it necessary to change the initial schedules. For instance, mechanical problems or local strikes may cause delays in connecting flights. Most importantly, bad weather conditions may reduce the number of landing slots available to airlines, as the FAA and airport authorities ration slots through Ground Delay Programs. Under these disruptions, major airlines need to rearrange flight schedules to maximize the network’s profitability, which requires the cooperation of their regional partners under several dimensions. If landing of a flight operated by the major is delayed, the major may want
8
the regional to delay a local flight used by the major’s passengers to connect to their final destinations. Relatedly, the major may want some regional partners to exchange landing slots (with the major or with each other) in order to allow the most strategically important flights to land on time. Slots are exchanged through a centralized mechanism called SCS (Slot Credit Substitution), under which the major asks for an immediate time slot from any airline (including its partners), in exchange for a later slot (Schummer and Vohray, 2013). If an airline accepts the exchange request, it foregoes a landing slot and thus it delays or cancels one of its flights.
These rescheduling and slot exchange decisions generate a potential conflict of interest between majors and their independent regional partners. First, delayed flights distort the schedules of airline employees, resulting in higher labor and logistics costs of which the regionals are residual claimants (Forbes and Lederman, 2009). Second, delaying flights operated for a major negatively affects the official performance record of regional airlines, and this may damage their future attempts to operate routes for other majors.
Most importantly for our purposes, the conflicts between major and independent regional partners over adaptation decisions do not appear to be fully resolved by formal contracts, either ex ante or ex post. Regarding ex post adjustments, the SCS slot exchange mechanism described above is purely voluntary – that is, majors do not contractually commit to compensate the regional partners who supply landing slots. This is not surprising because slot exchange decisions must be made rapidly and that leaves little room for majors and regionals to negotiate formal exchange agreements. Moreover, effective implementation of slot exchanges may require ongoing cooperation by the regional’s employees, such as prompt removal of an aircraft, which is hard to contractually define and verify.
Regarding the limitations of ex ante contracts, on the one hand, it is prohibitively costly for major airlines to specify adaptation decisions contingent on all possible combinations of in-route bad weather, strikes, and other adverse conditions. On the other hand, allocating decision rights ex ante may also fail to elicit efficient adaptation. While capacity purchase agreements sometimes assign to the major the formal right to
9
reschedule their regionals’ flights, 9 these rights cannot be used to enforce the non- contractible dimensions of the regional partner’s cooperation, as discussed above. Moreover, the regionals may refuse to provide slots demanded by the major under the expectation that given the contract’s incompleteness a court may consider the major’s demand abusive and contrary to good faith or custom (e.g., Schwartz, 1992; Bernstein, 1996).
Summing up these limitations of formal contracting in airline partnerships, Forbes and Lederman (2009) conclude that “contracts between majors and independent regionals are inherently incomplete [and] the transaction costs resulting from haggling between majors and independent regionals over ex post changes and adaptations are potentially large” (Forbes and Lederman, 2009, pp. 1834-35).
2.3. The importance of relationships
Despite the conflicts of interests and contractual frictions discussed above, both qualitative (through interviews with FAA officials and the former COO of a major airline) and quantitative evidence suggests that independent regionals informally cooperate with their major partners. On the one hand, conversations with the former COO suggest that majors informally compensate their regional partners for implementing schedule changes and supplying slots. In particular, majors informally count the flights cancelled by their regional partners as a consequence of requested slot exchanges as valid for their minimum contractual quota of operated flights. It is important to emphasize that the majors’ decision not to enforce the minimum quota in case of slot exchanges is fully discretionary – that is, capacity purchase agreements do not contain provisions obliging the major to do so.10
On the other hand, we provide descriptive evidence consistent with informal contracting of adaptation decisions by examining the population of slot exchanges among
9 See, for instance, the capacity purchase agreement between Continental Airlines and Express Jet Airlines signed on November 18, 2010, available at: http://agreements.realdealdocs.com/Purchase-and-Sale- Agreement/CAPACITY-PURCHASE-AGREEMENT-2801133. 10 Consistent with our qualitative evidence, US courts have upheld the majors’ right to enforce minimum quotas even in the presence of major-requested flight cancellations. See, for instance, the 2010 dispute between Delta and its regional partner Mesa Airlines (https://usatoday30.usatoday.com/travel/flights/2010- 05-18-mesa-air-delta-staff-cuts_N.htm). 10
U.S. commercial airlines under a Ground Delay Program in the three NYC airports (La Guardia, Newark and JFK) on February 24th, 2016. Table 1 cross-tabulates the airlines receiving slots (first two rows at the top) against those supplying slots (first column on the left). The first row lists all the major airlines. The second row lists each major airline’s regional partners, with partners owned by the major (including the major itself) in grey, and independent partners in white. For instance, Envoy Air (ENY), PSA Airlines (JIA) and Piedmont Airlines (PDT) are regional airlines owned by American Airlines (AAL), whereas Air Wisconsin (AWI), Trans States Airlines (LOF) and Republic Airline (RPA) are independent regional partners of American Airlines.
The third row lists the total number of slots each receiving airline got from all the supplying airlines combined. For instance, American Airlines received on this day a total of 106 slots, Envoy Air received three slots, etc., such that the total number of slots received by all airlines combined is 869. Rows from the fourth downwards list how many times a supplying airline has helped each receiving airline – that is, how many times the supplying airline has canceled or delayed some of its flights to satisfy a slot request by the receiving airline. For instance, American Airlines helped itself 75 times, American- owned partner Envoy Air helped American Airlines 6 times, independent American Airline’s partner Trans State Airlines helped American Airlines 9 times, etc.
The large boxes along the Table’s main diagonal display slot exchanges within partnerships, with bold cells representing cases in which the supplying airline is a vertically integrated partner of the receiving airline – that is, it is owned by or owns the receiving airline, or is owned by a major that also owns the receiving airline. In contrast, cells off the diagonal boxes represent slot exchanges between airlines that do not have a partnership relationship. Notice that the total number of times a receiving airline has been helped by a supplying airline, at the bottom of the receiving airline’s column, is typically larger than the total number of slots that airline has received. For instance, American Airlines has received a total of 106 slots but has been helped 161 times. The reason for this is that it usually takes more than one airline supplying slots to accommodate adaptation of a single landing slot demanded by a receiving airline.
11
Table 1 suggests that relationships with outsourcing partners are a key source of adaptation under adverse weather. First, American Airlines, Delta and United Airlines exchange an even higher share of slots with their outsourced partners (on average, 65%) than with their vertically integrated partners.11 Second, and most importantly, nearly all slot exchanges are located in the main diagonal boxes representing the American Airlines network, Delta network, and United network, implying that the slots supplied by independent regional airlines only go to their major partners or to other regional partners of those majors.12
<
We interpret these patterns as prima facie evidence of relational contracting given the limitations of formal contracts as a tool to govern slot exchanges and adaptation under inclement weather. In the remainder of the paper, we systematically test this hypothesis by showing that among pairs of major and regional airlines that are in a partnership (i.e., like those in the main diagonal boxes of Table 1), those with higher relationship value (1) are more likely to continue operating routes together after the 2008 industry-wide shock; and (2) exchange more landing slots during Ground Delay Programs.
Before presenting the empirical analysis, in the next section we formally derive our testable predictions from a simple model of relational contracting adapted to the airline industry.
3. A model of relational contracting in the airline industry
There are a major airline, M, and an independent regional airline, R, which may operate up to 𝑁 routes on M’s behalf. Both M and R are risk-neutral, live forever, and discount next-period payoffs by the factor 𝛿∈ 0,1 . Time evolves in discrete periods. We begin by describing the stage game in the first period, 𝑡 1.
11 The number of slot exchanges between a major and its outsourced partners is obtained by adding the non- bold numbers in the main diagonal box corresponding to that major in Table 1. The number of slot exchanges between a major and its integrated partners (including the major itself) is obtained by adding the bold numbers in the main diagonal box. 12 Table A1 in Appendix C provides a detailed description of how slot exchanges occur by reporting examples of slot exchange requests’ processing during a Ground Delay Program that took place on February 26th, 2016, at the NYC airport of La Guardia (LGA). 12
Outsourcing. M decides which of the 𝑁 routes to outsource to R. We write ℎ 1 if route 𝑖 is outsourced in period 1, and ℎ 0 otherwise. If ℎ 1, M offers to R a fixed fee, 𝑟 ∈ℝ, in exchange for operating the route. If R accepts, M pays the fee, and the
game moves to the next stage of period 1. If ℎ 0, or if R rejects M’s offer, M receives payoff 𝑚 , R receives zero, and the game moves to the next period, 𝑡 2. We may interpret 𝑚 as the maximum between M’s payoffs from not serving the route, operating the route itself,13 or outsourcing the route to an unmodeled suboptimal partner (R being the most efficient available outsourcing partner).
State. After the outsourcing decisions have been made, M and R observe on any given route 𝑖 the weather, 𝑤 ∈ 0,1 , where 𝑤 1 denotes bad weather, 𝑤 0 denotes
good weather, the probability of bad weather is 𝑝 ∈ 0,1 , and we assume for simplicity that weather realizations are independent across routes and periods. A “state” is a joint
realization of weather on all the 𝑁 routes, that is, a 𝑤 ,𝑤 ,…,𝑤 𝑁-uple out of the set of all possible joint weather realizations.
Adaptation. If M observes a bad weather state on route 𝑖, it asks R to adapt its flight schedule on that route (for instance, by giving a slot to M). Then, R chooses whether to adapt (𝑑 1) at cost 𝑐 or not (𝑑 0). If R adapts, M may pay a bonus, 𝑏 ∈ℝ, to compensate R’s adaptation cost.
Payoffs. Finally, M receives gross profit 𝑚 𝑑 ,𝑤 from any given outsourced route 𝑖, given the realized in-route weather and R’s adaptation decision.
At the beginning of the subsequent period, 𝑡 2, M and R may observe a negative permanent shock, 𝑧∈ 0,1 , where 𝑧 1 denotes the shock, and 𝑧 0 its absence. If 𝑧 0, the stage game from period 1 is repeated identically forever after. If 𝑧 1, the stage game is also repeated, except that now M’s gross profit from outsourcing a given
route 𝑖 permanently drops to 1 𝛼 𝑚 𝑑 ,𝑤 , and M’s outside option permanently 14 drops to 1 𝛼 𝑚 , from period 2 and thereafter. To derive testable predictions, we assume the size of the shock, 𝛼∈ 0,1 , is a random variable with pdf 𝑓 ∙ and cdf 𝐹 ∙
13 In this case, 𝑚 may include the higher labor costs under integration (the outsourcing labor costs being normalized to zero). 14 The model’s predictions would be unchanged if we also allowed the shock to reduce the discount factor 𝛿. 13
that M and R observe before making the period 2 outsourcing decisions.15 Consistent with the unexpected nature of the 2008 crisis that we analyze in the empirical section, we assume the shock 𝑧 is unlikely, in the sense that 𝑃𝑟 𝑧 0 1, and 𝑃𝑟 𝑧 1 0. Accordingly, we refer to the no-shock scenario, 𝑧 0, as “normal times”.