A model of endogenous borrowing constraints based on limited repayment enforcement and capital diversion shows that entrepreneurs’ output procyclicality increases their debt capacity, causing fluctuations in capital prices and expected aggregate output. Because project liquidation values are high when capital is expensive, creditors are more willing to finance projects that pay off in booms. Hence, procyclical entrepreneurs stretch their endowments further with leverage, allocating more capital to productive projects and driving up its price in the market. Even though the worst recessions occur after credit booms in which procyclical firms are highly levered, borrowing is inefficiently low from the second-best perspective.
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.