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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