Resolution of financial crises

Abstract

A financial crisis creates substantial wealth losses. How these losses are allocated is central to determine the magnitude of the crisis and the path to recovery. We study how institutions and technological factors that shape default and debt restructuring decisions affect the amplification and persistence of aggregate shocks. For large enough shocks, agents renegotiate. This limits the losses borne by borrowers, accelerating the recovery. The set of shocks that triggers renegotiation is decreasing in repossession costs and increasing in default costs, if the latter are public information. Private information about default costs leads to “V-shaped” recoveries: equilibrium default depresses output on impact, but by shielding borrowers’ net worth facilitates the recovery. These results are consistent with evidence from real estate markets in the U.S. during the Great Recession, and with features of the crises of Japan and South East Asia in the 1990s.

Keywords: Financial crises; balance sheet recessions; default; renegotiation.