Overborrowing, Financial Crises and ‘Macro-Prudential’ Policy?

Abstract

An equilibrium model of financial crises driven by Irving Fisher�sfinancial amplification mechanism features a pecuniary externality,because private agents do not internalize how the price of assetsused for collateral respond to collective borrowing decisions, particularlywhen binding collateral constraints cause asset fire-sales and leadto a financial crisis. As a result, agents in the competitive equilibriumborrow �too much� ex ante, compared with a financial regulator whointernalizes the externality. Quantitative analysis calibrated toU.S. data shows that average debt and leverage are only slightlylarger in the competitive equilibrium, but the incidence and magnitudeof financial crises are much larger. Excess asset returns, Sharperatios and the price of risk are also much larger, and the distributionof returns displays endogenous fat tails. State-contingent taxeson debt and dividends of about 1 and -0.5 percent on average respectivelysupport the regulator�s allocations as a competitive equilibrium.