Working Paper: NBER ID: w26985
Authors: Luigi Bocola; Guido Lorenzoni
Abstract: Financial crises typically arise because firms and financial institutions choose balance sheets that expose them to aggregate risk. We propose a theory to explain these risk exposures. We study a financial accelerator model where entrepreneurs can issue state-contingent claims to consumers. Even though entrepreneurs could use these contingent claims to hedge negative shocks, we show that they tend not to do so. This is because it is costly to buy insurance against these shocks as consumers are also harmed by them. This effect is self-reinforcing, as the fact that entrepreneurs are unhedged amplifies the negative effects of shocks on consumers’ incomes. We show that this feedback can be quantitatively important and lead to inefficiently high risk exposure for entrepreneurs.
Keywords: financial crises; risk exposure; state-contingent claims; financial institutions; policy responses
JEL Codes: E44; G01; G11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Lack of effective hedging by entrepreneurs (D81) | Amplification of negative shocks in the economy (E44) |
| Amplification of negative shocks in the economy (E44) | Reduced consumer incomes (D12) |
| Risk exposure of entrepreneurs (L26) | Negative impact on consumer income (F61) |
| Negative impact on consumer income (F61) | Self-reinforcing cycle of risk exposure (G41) |
| Optimal policy requires differential taxation of debt repayments (H21) | Mitigation of excessive risk-taking by entrepreneurs (G32) |