A Theoretical Framework for Law and Macro-Finance
46 Pages Posted: 28 Sep 2021
Date Written: September 28, 2021
What role (if any) should the design of the legal protections of creditors in bankruptcy law play in the regulatory frameworks for financial markets? In this paper, I consider the effects of such protections within the macro-financial theory of leverage cycles of John Geanakoplos. The central tenet of the theory is that leverage is procyclical. That effect exists because creditors tend to lend more in a credit boom, when their expectations for asset returns are optimistic than in a credit bust, when their expectations are pessimistic. I find that strong creditor rights have strong procyclical effects. In a credit boom, when expected asset returns are higher, leverage decreases, creating incentives for creditors to underwrite additional leverage without a substantial impact on its price. The stronger the rights, the more certain recoveries and, as a result, the incentives to underwrite additional debt. By creating such incentives, strong legal protections of creditors exacerbate the credit boom. In contrast, in a credit bust, when expectations for asset returns are pessimistic, strong creditor rights have procyclical effects because they incentivize creditors to force deleveraging or foreclose to maximize recoveries. On the positive side, the framework explains why countries with stronger creditor rights are more likely to experience a violent credit boom. On the normative side, the policy implication is that, in limited circumstances, the strength of creditor rights should be designed in a countercyclical fashion. Through a countercyclical design of creditor rights, policymakers should encourage creditors to lend into a credit bust but discourage them from lending into a credit boom. Recognizing the practical challenges of countercyclical adaptations of the strength of creditor rights, this paper suggests an alternative time-invariant regulatory framework implementing strict limits on leverage on all actors of the economy, from sovereigns, through banks, firms to households. The goal of the framework is to limit credit booms and smoothen the economic cycle.
Keywords: Collateral, Leverage, Liquidity, Law and Macroeconomics, Law and Macro Finance, Law and Finance
JEL Classification: E02, E32, E44, E61, G01, G18, G32, G33, O11, O43
Suggested Citation: Suggested Citation