Default and Punishment in General Equilibrium1

Abstract

We extend the standard model of general equilibrium with incomplete markets to allow for default and punishment by thinking of assets as pools. The equilibrating variables include expected delivery rates, along with the usual prices of assets and commodities. By reinterpreting the variables, our model encompasses a broad range of adverse selection and signalling phenomena in a perfectly competitive, general equilibrium framework.Perfect competition eliminates the need for lenders to compute how the size of their loan or the price they quote might affect default rates. It also makes for a simple equilibrium refinement, which we propose in order to rule out irrational pessimism about deliveries of untraded assets.We show that refined equilibrium always exists in our model, and that default, in conjunction with refinement, opens the door to a theory of endogenous assets. The market chooses the promises, default penalties, and quantity constraints of actively traded assets.

Credit risk in general equilibrium

“…While this feature makes the model not very useful to discuss the specific design of capital regulation for banks we believe that it provides clear perspective on the possibilities and limits of risk weight calibration based on traditional credit risk models and thus on the conceptual underpinnings of current capital regulation for banks. Related Research Our model builds on the literature on default in general equilibrium pioneered by Zame [1993] and Dubey et al [2005] and developed in various variations in Modica et al [1998], Araujo and Pascoa [2002] and Sabarwal [2003]. This literature in principle provides a framework that allows for an abstract analysis of endogenous credit risk.…”

“…The idea to model the costs of default as a utility penalty is due to Dubey et al [2005] and Zame [1993]. In our setup the consumer ex ante evaluates a consumption plan with respect to both the real consumption x i+ s and the default penalty…”

“…A bankruptcy occurs if agents cannot repay their due liabilities. In contrast to Zame [1993] and Dubey et al [2005], we do not allow agents to default on their loans. Agents will repay their debts as long as the value of their endowments and assets allows it.…”

“…This situation is somewhat reminiscent of general equilibrium models of money that always have equilibria where money has no value (see Gale [1982]). Zame [1993] and Dubey et al [2005] make attempts to exclude these kinds of equilibria through some kind of refinement. We believe however that the possibility of such trivial equilibria in a context of bankruptcy and default are entirely natural and should indeed be part of the model.…”

“…The seminal literature on credit risk in general equilibrium has indeed made the claim that the possibility of defaulting on loans may be welfare enhancing from an ex-ante viewpoint (see Dubey et al [2005], Zame [1993]). The mechanism by which this welfare enhancement comes about is based on risk transfer options the traded security structure allows for in an incomplete markets setting.…”