Since the worst employment slumps follow periods of high household debt and almost all household debt is provided by banks, we theoretically investigate whether bank regulation can play a role in stimulating employment. Using a competitive search model, we find that levered households suffer from a debt overhang problem that distorts their preferences, making them demand high wages. In general equilibrium, firms internalize these preferences and post high wages but few vacancies. This vacancy-posting effect implies that high household debt leads to high unemployment. Unemployed households default on their debt. In equilibrium, the level of household debt is inefficiently high due to a household-debt externality—banks fail to internalize the effect that household leverage has on household default probabilities via the vacancy-posting effect. As a result, household debt levels are inefficiently high. Our results suggest that a combination of loan-to-value caps for households and capital requirements for banks can improve efficiency, providing an alternative to monetary policy for labor market intervention.
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 commercial paper. The analysis of our model yields the following two main results. First, borrowing via debt with limited resaleability (via “non-negotiable” instruments) leads to credit chains. Second, increasing enforceability can, perversely, increase systemic risk. From a policy point of view, our results suggest that the bankruptcy safe harbors for repos are likely to exacerbate systemic risk.
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 four main results. First, efficient project choices arise in equilibrium for only intermediate levels of competition. Entrepreneurs invest excessively in (riskier) specialized projects at low levels of credit market competition, and invest excessively in (safer) standardized projects at high levels of credit market competition. Second, the emergence of relationship lending eliminates the investment inefficiency for low levels of competition, but not the inefficiency for high levels of competition. Third, this residual investment inefficiency encourages the emergence of highly levered specialized intermediaries that resemble private equity firms and that eliminate the investment inefficiency at high levels of competition. Fourth, these private equity firms arise only in competitive credit markets and fund only specialized projects with high expected returns. The model thus explains the co-existence of bank lending and private equity funding in general equilibrium.
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.