DP11678 Divergent Reference-Dependent Risk-Attitudes and Endogenous Collateral Constraints

Author(s): Giuliano Curatola, Ester Faia
Publication Date: December 2016
Date Revised: September 2018
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: cepr.org/active/publications/discussion_papers/dp.php?dpno=11678

The booms preceding financial crises typically feature high exposure to risky assets, high leverage, asset price growth and low debt margins, which are then followed by sharp de-leveraging after the crisis. We build a model that endogenously generates such heightened leverage/deleverage cycle and asset price boom/bust with three elements. First borrowers exhibit gain-loss preferences around a time-varying reference level, hence they are increasingly risk tolerant at the upper tails and this fosters debt and risky asset demand, while they are loss-averse on the lower tails, something which fosters de-leveraging. Second they are subject to occasionally binding collateral constraints and third, there is heterogeneity in risk-attitudes between borrowers and lenders. The latter implies that the debt margin varies endogenously and countercyclically to close the gap between lenders/borrowers evaluations (namely debt demand and supply). We solve the model analytically and numerically, through a global method, namely policy function iterations with endogenously Markov-switching regimes. Numerically the model 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.