Lender Expertise and

Propagation of Credit Shocks

Garey RameyUC San Diego

July 2009

Previous literature: “Constrained borrower” view

Stiglitz and Weiss (1981), Bernanke and Gertler (1989,1990), Kiyotaki and Moore (1997), Hölmstrom and Tirole (1997,1998)

Wealth constrained agency

Previous literature: “Constrained borrower” view

Stiglitz and Weiss (1981), Bernanke and Gertler (1989,1990), Kiyotaki and Moore (1997), Hölmstrom and Tirole (1997,1998)

Injurious liquidation

Diamond and Dybvig (1983), Schleifer and Vishny (1992), Hölmstrom and Tirole (1997),

Wealth constrained agency

Previous literature: “Constrained borrower” view

Stiglitz and Weiss (1981), Bernanke and Gertler (1989,1990), Kiyotaki and Moore (1997), Hölmstrom and Tirole (1997,1998)

Injurious liquidation

Diamond and Dybvig (1983), Schleifer and Vishny (1992), Hölmstrom and Tirole (1997),

Wealth constrained agency

Key idea: Shocks propagate by affecting borrower collateral

This paper: “Constrained lender” view

1. Specialized lenders channel saving to investment – “Brealey-Myers managers”

This paper: “Constrained lender” view

1. Specialized lenders channel saving to investment – “Brealey-Myers managers”

2. Lenders form long-term contractual relationships with projects, subject to agency costs

This paper: “Constrained lender” view

1. Specialized lenders channel saving to investment – “Brealey-Myers managers”

2. Lenders form long-term contractual relationships with projects, subject to agency costs

3. Averse shocks break up projects, lenders take time to find new projects

This paper: “Constrained lender” view

1. Specialized lenders channel saving to investment – “Brealey-Myers managers”

2. Lenders form long-term contractual relationships with projects, subject to agency costs

3. Averse shocks break up projects, lenders take time to find new projects

4. Household asset reallocation creates negative feedback

This paper: “Constrained lender” view

1. Specialized lenders channel saving to investment – “Brealey-Myers managers”

2. Lenders form long-term contractual relationships with projects, subject to agency costs

3. Averse shocks break up projects, lenders take time to find new projects

4. Household asset reallocation creates negative feedback

Den Haan, Ramey and Watson, “Liquidity Flows and Fragility of Business Enterprises,” JME, 2003

Results

1. Agency costs shocks propagated through lender-project relationships

Results

1. Agency costs shocks propagated through lender-project relationships

2. Household responses amplify propagation

Results

1. Agency costs shocks propagated through lender-project relationships

2. Household responses amplify propagation

3. Propagation is greater when shocks are more persistent

Results

1. Agency costs shocks propagated through lender-project relationships

2. Household responses amplify propagation

3. Propagation is greater when shocks are more persistent

4. Asset market feedbacks shocks propagate across sectors

Broader contribution:

New approach to modeling saving and investment

Broader contribution:

New approach to modeling saving and investment

Traditional model: Capital = accumulated output

Broader contribution:

New approach to modeling saving and investment

Traditional model: Capital = accumulated output

Lender expertise model: Capital = accumulated managerial knowledge

Model

• Unit mass of households

• Unit mass of specialized lenders

• Periods t = 1,2,3,…

Model

• Unit mass of households

• Unit mass of specialized lenders

• Periods t = 1,2,3,…

• In each period, a lender is either matched with a project or searching for a new project

tnt periodin produce that projects ofnumber

Model

• Unit mass of households

• Unit mass of specialized lenders

• Periods t = 1,2,3,…

• In each period, a lender is either matched with a project or searching for a new project

tnt periodin produce that projects ofnumber

ianz ittt project ofoutput 1

itit aaG offunction on distributi )(

lueproject va )( itt aV

lender unmatched of valuetU

Project surplus

lueproject va )( itt aV

lender unmatched of valuetU

Project surplus

tittitt U(aVaS ) surplusproject )(

lueproject va )( itt aV

lender unmatched of valuetU

yprobabilit eobsolesenc exogenous

Project surplus

tittitt U(aVaS ) surplusproject )(

}0,])'()'()1[(max{0

1111

ttttittt UadGaSEanz

factordiscount stochastic 1 t

costagency x

surplusproject from extractedrent

Surplus must cover this cost or project is terminated – Ramey and Watson (1997,1999,2000)

Agency cost

costagency x

surplusproject from extractedrent

Surplus must cover this cost or project is terminated – Ramey and Watson (1997,1999,2000)

Agency cost

marginrmination project te tR

xRS tt )(

costagency cover tosurplus sufficient tit Ra

d terminateisproject surplus,nt insufficie tit Ra

Project search

lenders searching ofnumber 1 tt nv

yprobabilit findingproject }1,min{ tt Avp

Project search

lenders searching ofnumber 1 tt nv

yprobabilit findingproject }1,min{ tt Avp

0

111 ])'()'([ tttttt UadGaSpEU

Equilibrium conditions

1

)'()'( 1

tRt xadGRa

1111

1 )1(

tttttttt nzEpRnz

Equilibrium conditions

1

)'()'( 1

tRt xadGRa

1111

1 )1(

tttttttt nzEpRnz

))1))(((1( 11 ttttt vpnRGn

Equilibrium conditions

1

)'()'( 1

tRt xadGRa

tR

ttt adGanzy output aggregate )'('

1111

1 )1(

tttttttt nzEpRnz

))1))(((1( 11 ttttt vpnRGn

Asset market

functionutility household 10

1

0

t

tt cE

tt yc cost agency consumes Household

11

t

tt y

y

Asset market

functionutility household 10

1

0

t

tt cE

Driving process

11

tezz tt

tt yc cost agency consumes Household

11

t

tt y

y

Numerical example

2. ,0 lognormal, )( itaG

22. that sochosen AvA

8.,1,99.,02.,8.

Numerical example

2. ,0 lognormal, )( itaG

22. that sochosen AvA

8.,1,99.,02.,8.

07.)(,56.1,78.,72. RGynR

:statesteady 1x

Numerical example

2. ,0 lognormal, )( itaG

22. that sochosen AvA

8.,1,99.,02.,8.

02.)(,90.1,92.,0 RGynR

07.)(,56.1,78.,72. RGynR

:statesteady 1x

:statesteady 0x

Extensions

1. Lender effort

Extensions

1. Lender effort

2. Physical capital

Extensions

1. Lender effort

2. Physical capital

3. Long-term contracting, liquidity hoarding

Extensions

1. Lender effort

2. Physical capital

3. Long-term contracting, liquidity hoarding

4. Countercyclical policy – “bailouts”