50 Pages Posted: 7 Nov 2011
Date Written: September 7, 2011
In the presence of uninsurable idiosyncratic risk, the optimal credit contract allows for the possibility of default. In addition, the optimal contract incorporates a precautionary savings motive over and above what agents would otherwise save. When default is sufficiently high, credit markets may collapse. A regulatory requirement on the level of savings can increase risk-sharing and improve welfare by increasing the gains to trade in credit exchange. Under the appropriate verifiability condition on the level of savings, an appropriate market structure, agents voluntarily increase their level of storage such that trade and welfare improve.
Keywords: Uninsurable Risk, Credit, Default, Endogenous Contracts, Precautionary Savings
JEL Classification: D52, D53, E21
Suggested Citation: Suggested Citation