Overborrowing, Financial Crises
and ‘Macro-prudential’ Policy
Javier Bianchi University of Wisconsin
Enrique G. Mendoza University of Maryland & NBER
The case for macro-prudential policies
• Credit booms are often followed by deep recessions,
asset price crashes, and banking crises
– Credit booms occurred with 2.8% frequency in 1960-2010, and
about 1/3 featured banking crises (Mendoza & Terrones (12))
– …in this sense the 2008-09 global crisis had a “typical” pattern.
• Macro-prudential policy (MPP) has a clear goal: to
prevent “overborrowing” at the macro level by affecting
agents’ behavior ex ante
• …but specifics of MPP design are less clear
– Theoretical models motivate quantity/price strategies, but
quantitative models of the effects of MPP are scarce
Two key quantitative questions
• Can a micro-level financial friction cause significant
systemic (or macro) overborrowing?
– Can it explain financial crises or affect business cycles?
– Sound MPP starts with a “good” model of crises
– Similar question as in the broad literature on financial frictions
• Is macroprudential policy effective to prevent
overborrowing and financial crises?
– What are its main features?
– How does it affect incidence and magnitude of financial crises?
– What are its effects on asset pricing behavior (excess returns,
Sharpe ratios, price of risk)?
What we do in this paper
• Answer the questions using an equilibrium asset pricing
model with a collateral constraint.
– Compare decentralized eq. (DE) with a “conditionally efficient”
social planner (SP) subject to IDENTICAL credit possibilities.
• The credit constraint plays two key roles:
1. Triggers Fisher's debt-deflation feedback mechanism, which
causes deep recessions via financial amplification
2. Introduces a pecuniary externality via price of collateral assets
(in “good times” agents do not internalize that lower leverage
weakens Fisherian deflation in “bad times”)
A planner that reduces debt ex ante improves welfare.
Related literature
• Pecuniary credit market externalities:
– Participation constraints: Jeske (06), Wright (06), Lustig (00)
using Kehoe & Levine (93)
– Collateral constraints: Caballero & Krishnamurthy (01),
Lorenzoni (08), Korinek (09), Stein (10), survey by Galati and
Moessner (11)...
– Quantitative studies: Bianchi (09), Nikolov (09), Jeanne &
Korinek (10), Benigno et al. (10)...
• Amplification effects of financial frictions:
– Bernanke & Gertler (89), Kiyotaki & Moore (97), Bernanke,
Gertler & Gilchrist (99), Aiyagari & Gertler (99), Kocherlakota
(00), Mendoza & Smith (06), Mendoza (10)….
Main findings
1. DE and SP yield similar average debt and leverage
2. …but crises are larger and more frequent in DE
– Probability of financial crises increases by a factor of 3.
– Asset prices fall 17 ppts more (24% v. 7% for SP).
– Credit and consumption fall about 10 ppts more
– Overall cyclical variability is also higher
3. Mean excess return and Sharpe ratio rise by factors
of 6 and 10, and market price of risk increases 81%.
4. SP’s allocations implementable with state-contingent
taxes on debt (1% on average, positively corr. with
leverage) and on dividends (-0.4% on average)
Main elements of the model
• Inter-period non-state-contingent debt for self insurance
& intra-period debt for working capital (WK)
• Collateral constraint limits total debt to fraction of market
value of physical assets (in fixed supply)
• Production with labor and physical assets
• WK has zero financing cost but requires collateral
• Standard TFP shocks only (crises with realistic features
result from endogenous amplification)
• GHH preferences remove wealth effect on labor supply
Representative firm-household problem
in the decentralized economy
• Maximize:
s.t. budget constraint
and collateral constraint
Decentralized equilibrium conditions
Asset pricing conditions
• Excess asset returns:
• Forward solution for asset prices:
Social Planner's problem
Taking as given
Pecuniary credit externality
• DE’s private marginal utility cost of borrowing:
• SP’s social marginal utility cost of borrowing:
where and
Optimal macro-prudential policy
• Decentralize planner’s eq. with state contingent taxes
• Tax on debt implements SP’s bond decision rule:
• Tax on dividends makes asset prices equivalent:
Calibration
Decision rules for bonds in low TFP state
l.r. prob:
DE 27%
SP 29%
l.r. prob:
DE 70%
SP 69%
l.r. prob:
DE 4%
SP 2%
Equilibrium land prices in low TFP state
Debt dynamics: amplification effects
bt+1=bt
bt
bt+1
Long-run distribution of leverage ratio
Comparison of financial crisis events
• Simulate DE and SP economies for 100,000 periods.
• Define crisis events: binding credit constraint with fall
in credit of more than 1sd.
• Construct 5-year windows centered in crisis periods.
• Compute median shocks in [t-2, t-1, t, t+1, t+2] and
median initial debt at t-2.
• Simulate ‘DE’ and ‘SP’ given initial debt and
sequence of shocks, and compare also against ‘fixed
price’ case (constant collateral price)
Differences in asset pricing properties
• Collateral constraint causes sharp drop in asset
demand, and leads to higher and
• Sharpe ratio rises because rises more than
(DE overcompensates risk-taking)
• The market price of risk rises
• Endogenous “fat tails” in distribution of asset returns
Asset pricing moments
Endogenous “fat tails” in CDF of returns
Sensitivity analysis: key parameters
• Collateral coefficient (loan-value ratio):
– Affects collateral’s response to given price effects
– Negatively related to probability of a binding constraint.
– …but effects are nonlinear (Fisherian deflation removed at =0
and also for large, nonbinding ’s)
• Risk aversion coefficient:
– Affects price elasticity of asset demand
– Disutility from binding constraints
• Frisch elasticity of labor supply:
– Higher elasticity produces larger output drops
– Smaller wage effects on collateral constraint
Sensitivity Analysis
Sensitivity analysis
Conclusions and future work
• Collateral constraints introduce systemic pecuniary
externality that increase magnitude and incidence of
financial crises, mean excess returns, volatility of
returns and Sharpe ratios
• Optimal MPP taxes on debt and dividends neutralize
externality, but implementation is difficult:
– State-contingent policies that require detailed information on
debt and leverage of a large set of economic agents
– Taxing dividends during crises politically difficult, but
selective implementation reduces welfare
• MPP has to adapt to fin. innovation and differences in
information/beliefs (Bianchi, Boz & Mendoza (2012))
U.S. household debt relative to the
value of residential land
Decentralized equilibrium in recursive form
solve:
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