In this paper, I present a general equilibrium model with limited enforcement to explore how the cyclicality of firms’ output affects corporate borrowing, asset prices, and social welfare. I show the following three main results. First, firms with more procyclical output have higher debt capacities than firms with less procyclical output. Second, assets with more procyclical output trade at a premium over assets with less procyclical output. This is due to a collateral premium that replaces the insurance premium in models based on risk aversion. Third, a social planner should tax firms with less procyclical output to subsidize firms with more procyclical output. This policy increases welfare even though it amplifies the business cycle. Each of these results reflects the ability for procyclicality to mitigate two pervasive enforcement fictions—capital diversion and renegotiation. The results contrast with the established conclusions of the theory literature, but are consistent with empirical findings about corporate leverage and asset prices.
How does competition among financiers affect the nature of borrowers’ investments in the economy and how does this, in turn, affect which financial intermediaries arise as lenders in equilibrium? This paper develops a general equilibrium model to address these questions. There are three main results. First, at low levels of credit market competition, firms invest excessively in (riskier) specialized projects, whereas, at high levels of credit market competition, firms invest excessively in (safer) standardized projects. Efficient project choices arise in equilibrium for only intermediate levels of competition. Second, the emergence of relationship lending eliminates the inefficiency for low levels of competition, but not the inefficiency for high levels of competition. Third, this residual inefficiency encourages the emergence of specialized intermediaries that resemble private equity firms; they arise only when credit market competition is sufficiently high, and are shown to be highly levered.
with Giorgia Piacentino
We propose a model of delegated investment with a public signal that suggests that (i) contracts do not have to refer to the public signal in order to overcome incentive problems; (ii) contracts include references to the public signal not to address incentive problems, but rather to help agents compete; and, in contrast to the contracting literature, (iii) decreasing the precision of the public signal leads to Pareto improvements. We apply this framework to a problem of delegated portfolio choice in which contracts make references to credit ratings. Our model suggests that wider rating categories make everyone better off.
with Eva Micheler
In this paper, we study the question of how the asymmetric legal treatment of different types of debt affects systemic risk. To address this question, we construct a corporate finance model in which the enforceability of claims is limited. In the model, a bank can choose to borrow via debt claims that may differ along two legal dimensions, resaleability and bankruptcy seniority. These dimensions reflect the legal asymmetries that exist between, for example, repos and bonds. The analysis of our model yields the following three main results. First, credit chains are the result of financial institutions being hit by liquidity shocks after they have lent via debt with limited resaleability (via ``non-negotiable’’ instruments). Second, increasing enforceability can, perversely, increase systemic risk. And, third, the super-seniority of non-negotiable instruments such as repos likely exacerbates systemic risk.