Leverage Restrictions in a Business Cycle Model

By Lawrence Christiano and Daisuke Ikeda

http://d.repec.org/n?u=RePEc:chb:bcchwp:726&r=dge

We modify an otherwise standard medium-sized DSGE model, in order to study the macroeconomic effects of placing leverage restrictions on financial intermediaries. The financial intermediaries (‘bankers’) in the model must exert effort in order to earn high returns for their creditors. An agency problem arises because banker effort is not observable to creditors. The consequence of this agency problem is that leverage restrictions on banks generate a very substantial welfare gain in steady state. We discuss the economics of this gain. As a way of testing the model, we explore its implications for the dynamic effects of shocks.

This paper highlights how special the financial sector is and how putting (particular) restrictions on it can have significant positive impact. In this case, it all boils down to whether it is observable whether we can see how well the banker selects and monitors loans. As the banker use the funds of others, he is not getting the full returns from his efforts and does not try hard enough. And imagine if there where also some other perverse incentives in the model, like limited liability or a bonus pay system that would encourage investing in excessively risky projects.

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