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Debt Dilution and Debt Overhang
(with Immo Schott)
(New Version: August 2018, submitted)
Barcelona GSE Working Paper 997
We introduce long-term debt (and a maturity choice) into a dynamic model of
firm financing and production. This allows us to study two distortions which are
absent from standard models of short-term debt: (1.) Debt dilution distorts firms’
choice of debt; (2.) Debt overhang distorts investment. In a dynamic model of
production, leverage, and debt maturity, we show that the two distortions interact
to reduce investment, increase leverage, and increase the default rate. We find that
the macroeconomic effects of debt dilution and debt overhang can be important:
A financial reform which increases investment, output, and welfare in a standard
model of short-term debt can have the opposite effect in a model with short-term
debt and long-term debt.
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Slow Debt, Deep Recessions
(with Immo Schott)
(December 2018)
Business credit lags GDP growth by about one year. This contributes to high
leverage during recessions and slow deleveraging. We show that a model in which
firms borrow long-term can replicate the sluggish adjustment of fi rm debt. In the
model, slow-moving debt has important effects for real activity. High levels of fi rm
debt issued during expansions are only gradually reduced during the subsequent
downturn. This generates an adverse feedback loop between low investment and
high credit spreads and thereby amplifi es the downturn. Sluggish deleveraging
slows down the recovery. The equilibrium is constrained ineffi cient because fi rms
exert an externality on the holders of previously issued debt. We study optimal
stabilization policies. State-contingent debt taxes and investment subsidies can
reduce macroeconomic volatility by about one third.
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Bank Opacity and Financial Crises
Journal of Banking & Finance, Vol. 97, December 2018, pp. 157-176
Working Paper;
Barcelona GSE Focus
This paper studies a model of endogenous bank opacity. Why do banks choose to hide their risk
exposure from the public? And should policy makers force banks to be more transparent? In the model,
bank opacity is costly because it encourages banks to take on too much risk. But opacity also reduces
the incidence of bank runs (for a given level of risk taking). Banks choose to be inefficiently opaque
if the composition of their asset holdings is proprietary information. In this case, policy makers can
improve upon the market outcome by imposing public disclosure requirements (such as Pillar Three of
Basel II). However, full transparency maximizes neither efficiency nor stability. The model can explain
why empirically a higher degree of bank competition leads to increased transparency.
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