DP11678 Divergent Risk-Attitudes and Endogenous Collateral Constraints

Author(s): Giuliano Curatola, Ester Faia
Publication Date: December 2016
Date Revised: September 2017
Keyword(s): endogenous price of risk, excessive leverage, loss averse borrowers, occasionally binding constraints, risk-tolerance
JEL(s): E0, E5, G01
Programme Areas: Financial Economics, International Macroeconomics and Finance, Monetary Economics and Fluctuations
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=11678

In the booms preceding financial crises borrowers typically exhibit more risk-tolerance at the upper tails relatively to lenders. This results in high exposure to risky assets, leverage and asset price growth and low debt margins, followed by sharp de-leveraging after a financial crisis occurs. We build a model with borrowers featuring gain-loss preferences around a time-varying reference level (borrowers are increasingly risk-tolerant at the upper tails and are loss-averse on the lower tails), who are subject to occasionally binding collateral constraints and with heterogeneity in risk-attitudes between borrowers and lenders (so that debt margins are endogenous). We solve the model analytically and numerically, through policy function iterations with endogenously Markov-switching regimes. The model endogenously generates a heightened leverage/deleverage cycle and boom/bust in asset prices. Numerically it matches well several moments for asset prices, returns, equity premia and Sharpe ratio, the volatility of leverage, its procyclicality and the counter-cyclicality of the debt margins.