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Divergent Risk-Attitudes and Endogenous Collateral Constraints

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  • Curatola, Giuliano
  • Faia, Ester

Abstract

Consensus exists that financial crises are triggered by excessive leverage and low risk-sensitivity at the tails, together leading to endogenous risk-formation. A large body of literature explored the first determinant. None combined the two. We build a model with heterogenous agents, occasionally binding collateral constraints and loss-averse borrowers with kinked preferences (diminishing risk sensitivity on the tails). The shadow price of debt (the tightness of the constraint), hence the risk of a crisis, derives endogenously by the distance in borrowers/lenders pricing kernels. Analytically we prove that: the tightness of the borrowing limit increases in the pricing kernels' distance and decreases in borrowers' risk-tolerance; the borrowers' Sharpe ratio raises with respect to his pricing kernel and to the shadow price of debt. We quantify the transmission channels by simulating the model with Markov-switching regimes, which account for anticipatory effects of the occasionally binding borrowing limit and of the preference status around the kink. Among other things we find that our model matches well several facts about asset prices, returns and consumption.

Suggested Citation

  • Curatola, Giuliano & Faia, Ester, 2016. "Divergent Risk-Attitudes and Endogenous Collateral Constraints," CEPR Discussion Papers 11678, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:11678
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    References listed on IDEAS

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    Cited by:

    1. Faia, Ester & Paiella, Monica, 2017. "P2P Lending: Information Externalities, Social Networks and Loans' Substitution," CEPR Discussion Papers 12235, C.E.P.R. Discussion Papers.

    More about this item

    Keywords

    endogenous price of risk; excessive leverage; loss averse borrowers; occasionally binding constraints; risk-tolerance;

    JEL classification:

    • E0 - Macroeconomics and Monetary Economics - - General
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • G01 - Financial Economics - - General - - - Financial Crises

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