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Resolution of financial crises

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  • Fanelli, Sebastián
  • Gonzalez-Eiras, Martín

Abstract

A financial crisis creates substantial wealth losses. How these losses are allocated determines the magnitude of the crisis and the path to recovery. We study how institutions and technological factors that shape default and debt restructuring decisions affect the amplification of aggregate shocks. For sufficiently large shocks, agents renegotiate. This limits the losses borne by borrowers, shutting the amplification mechanism via asset prices. The range of shocks that trigger renegotiation is decreasing in repossession costs and increasing in default costs, if the latter are public information. Private information may induce equilibrium default but, by allowing agents with high default costs to extract a larger haircut, facilitates the recovery. The model is consistent with evidence from real estate markets in the U.S. during the Great Recession; and rationalizes recent changes in U.S. Bankruptcy Code in the wake of the COVID-19 crisis.

Suggested Citation

  • Fanelli, Sebastián & Gonzalez-Eiras, Martín, 2021. "Resolution of financial crises," Journal of Economic Dynamics and Control, Elsevier, vol. 133(C).
    • Handle: RePEc:eee:dyncon:v:133:y:2021:i:c:s0165188921001871
    DOI: 10.1016/j.jedc.2021.104252
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    Keywords

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    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G01 - Financial Economics - - General - - - Financial Crises

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