Series: Working Papers. 2214.
Author: Henrique Basso.
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Abstract
Imperfect information aggregation in secondary credit markets has significant consequences for economic cycles. As banks put more weight on mark-to-market gains, they find it optimal to refrain from revealing information about adverse shocks. Consequently, default risk is mispriced, and loan volumes, and thus investment, are not appropriately reduced. Overinvestment lowers the price of capital, leading households to increase consumption without decreasing labour supply, generating a boom. Due to mispricing, banks subsequently face bigger losses and capital depletion. Output then decreases sharply due to credit supply shortages. In a model calibrated to the US economy, these instances of market dysfunction are crucial in amplifying credit cycles.