Balance Sheet Recessions with Informational and Trading Frictions
53 Pages Posted: 17 Feb 2015 Last revised: 13 Aug 2015
Date Written: July 22, 2015
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 imposing (or subsidizing) contingencies in private contracts is welfare improving.
Keywords: Balance sheet recessions, contingent contracts, liquidity, informational frictions, trading frictions, financial regulation
JEL Classification: E32, E44, G1
Suggested Citation: Suggested Citation