A Theory of Balance Sheet Recessions with Informational and Trading Frictions

I propose a novel theory to rationalize limited sharing of macroeconomic risk that drives balance sheet recessions as a result of informational and trading frictions in financial markets. I show that borrowers and creditors will find it costly to share macroeconomic risk in environments where creditors value the liquidity of financial claims but where information about the future states of the economy is dispersed and the secondary markets for financial claims feature search frictions. As a result, borrowers will optimally choose to retain disproportionate exposures to macroeconomic risk on their balance sheets, and adverse shocks will be amplified through the balance sheet channel. I show that the magnitude of this amplification becomes closely linked to the level of information dispersion and the severity of search frictions. In this setting, I study the implications of the theory for macro-prudential regulation and find that subsidizing contingent write-downs of borrowers’ liabilities can be welfare improving.