29 enero 2015

Balance Sheet Recessions with Informational and Trading Frictions . Vladimir Asriyan

Barcelona GSE Working Paper No. 806

Title: Balance Sheet Recessions with Informational and Trading Frictions
Authors: Vladimir Asriyan
Date: 15-01-2015
Keywords: balance sheet recessions, contingent contracts, liquidity, informational frictions, trading frictions, financial regulation
JEL Codes: E32, E44, G01

Balance sheet recessions result from concentration of macroeconomic risks on the balance sheets of leveraged agents. In this paper, I argue that information dispersion about the future states of the economy combined with trading frictions in financial markets can explain why such concentration of risk may be privately but not socially optimal. I show that borrowers face a tradeoff between the insurance benefits of financing with macro contingent contracts and the illiquidity premia they need to pay creditors for holding such contracts. In aggregate, as borrowers sacrifice contingency in order to provide liquidity, the severity of macroeconomic fluctuations becomes endogenously linked to the magnitudes of information dispersion and trading frictions. In this setting, I study the policy implications of the theory and I find that subsidizing contingencies in private contracts is welfare improving; in particular, policies that solely target borrowers' leverage are sub-optimal.

The Great Recession has once again underscored the important role that financial frictions play in the amplification and propagation of macroeconomic shocks. We were again reminded that the concentra- tion of macroeconomic risks on the balance sheets of leveraged agents can produce powerful feedback effects and turn shocks of small magnitude into full-blown balance sheet recessions.1 As an example, the disproportionate exposure of leveraged households to real estate risks is thought to have been responsible for the large and prolonged drop in consumption and employment in the recent recession, and similar arguments have been made of the contribution of the financial sector to the recession.2 Although the literature has long recognized that balance sheet recessions can result from the com- bination of leverage and concentrated risks, we do not have a good understanding of why borrowers often choose to retain so much risk on their balance sheets to begin with. Answering this question is particularly important for policy makers to design an effective framework for financial regulation.
Much of the existing literature on balance sheet recessions assumes that borrowers and creditors cannot write contracts contingent on the aggregate states of the economy. However, the typical agency-based explanations for why these contingencies may be limited do not apply to aggregate states: atomistic agents cannot influence aggregate outcomes and in many cases there are readily available indicators that can be used in contracting (e.g. GDP, real estate indices, inflation).3 This is particularly important since our standard models predict that agents’ ability to contract on aggregate states can generate sufficient risk-sharing so as to eliminate the balance sheet amplification mechanism altogether.4

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Spain; Email: vasriyan@crei.cat; Website: https://sites.google.com/site/vasriyan. Acknoledgments: I am indebted to my advisors William Fuchs, Yuriy Gorodnichenko, Pierre-Olivier Gourinchas, and Demian Pouzo for their support and invaluable guidance. I also thank Liang Bai, Matthew Botsch, Fernando Broner, Julie Cullen, Sebastian Di Tella, Haluk Ergin, Ben Faber, Nicolae Gaˆrleanu, Brett Green, Terrence Hendershott, Amir Kermani, Scott Kostyshak, Gustavo Manso, Pascal Michaillat, John Mondragon, Takeshi Murooka, Maury Obstfeld, Aniko O ̈ery, Marcus Opp, Alberto Martin, Christine Parlour, Romain Ranci`ere, Ana Rocca, Andr ́es Rodr ́ıguez-Clare, David Romer, Michel Serafinelli, Viacheslav Sheremirov, Asrat Tesfayesus, Robert Townsend, Victoria Vanasco, Jaume Ventura, Johan Walden, and seminar participants at UC Berkeley, CREi - Universitat Pompeu Fabra, Barcelona GSE, the Federal Reserve Board, the World Bank, EIEF - Rome, Universita Bocconi, Universitat de Barcelona, the Society for Economic Dynamics, the 7th Joint French Macro Workshop, and the European Winter Meeting of the Econometric Society for helpful suggestions and comments. I also thank Yimei Zou for excellent research assistance.