Risk externalities

Abstract

Current analysis of macro-prudential policy has largely focused on excessive leverage and fire sales, while abstracting from firm-level risk and portfolio decisions. We show that these matter for the design of optimal interventions. We study a macroeconomic model in which firms make investment decisions in the presence of both aggregate and firm-specific risk. Financial constraints limit access to external funds and tie each firm's output to its net worth and a firm-specific return on investment. The laissez-faire outcome is constrained inefficient, as individual decisions fail to internalize their consequences on the distribution of risky returns over other agents (a risk externality). Firms are, at the same time, overexposed to aggregate risk and underexposed to idiosyncratic risk. In a quantitative exploration, interventions are shown to be counter-cyclical in their magnitude and to lead to large increases in aggregate TFP and output.