A Theoretical Framework for Law and Macro-Finance

Abstract

This article considers the effects of the legal protections of creditors within the macro- financial theory of leverage cycles of John Geanakoplos and proposes a theoretical framework, Law and Macro Finance, comprising two main clams: (1) the strength of the legal protections of creditors has an impact on the quantum of debt creditors are willing to underwrite not just the interest rate on that debt and (2) that quantum varies across the cycle. In a boom, when asset prices are higher, leverage decreases, creating incentives for creditors to underwrite additional leverage secured on those assets without increasing the interest rate. The stronger the legal protections of creditors, the stronger the incentives to underwrite additional leverage based solely on the increasing value of the collateral. By creating such incentives, strong legal protections of creditors, associated with claims designated in the law as ‘bankruptcy remote,’ accelerate the boom, and increase the vulnerability of the economy to shocks. On the normative side, this article proposes a countercyclical design of strong legal protection of creditors. The design makes the availability of such protections, typically achieved by reliance on the legal doctrine of ‘true sales,’ conditioned on the adequacy of the price paid in the transaction. The adequacy, in turn, is determined in reference to the applicable schedule of collateral haircuts determined by the central bank.

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