Endogenous debt constraints in collateralized economies with default penalties

The objective of the paper is to propose endogenous debt constraints that rule out Ponzi schemes and ensure the existence of equilibria in a model with limited commitment and (possible) default. We appropriately modify the definition of finitely effective debt constraints, introduced by Levine and Z...

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Bibliographic Details
Published in:Journal of mathematical economics 2012, Vol.48 (1), p.1-13
Main Authors: Martins-da-Rocha, V. Filipe, Vailakis, Yiannis
Format: Article
Language:English
Subjects:
Collateral
Debt
Debt constraints
Debt management
Default
Economics and Finance
Equilibrium models
External borrowing
External financing
Financial theory
Fines & penalties
Humanities and Social Sciences
Incomplete markets
Infinite horizon economies
Limited commitment
Mathematical economics
Pay-off
Ponzi schemes
Pyramid operations
Studies
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Summary:The objective of the paper is to propose endogenous debt constraints that rule out Ponzi schemes and ensure the existence of equilibria in a model with limited commitment and (possible) default. We appropriately modify the definition of finitely effective debt constraints, introduced by Levine and Zame (1996) (see also Levine and Zame (2002)), to encompass models with limited commitment, default penalties and collateral. Along this line, we introduce in the setting of Araujo et al. (2002), Kubler and Schmedders (2003) and Páscoa and Seghir (2009) the concept of actions with finite equivalent payoffs. We show that, independent of the level of default penalties, restricting plans to have finite equivalent payoffs rules out Ponzi schemes and guarantees the existence of an equilibrium that is compatible with the minimal ability to borrow and lend that we expect in our model. An interesting feature of our debt constraints is that they give rise to budget sets that coincide with the standard budget sets of economies having a collateral structure but no penalties (as defined in Araujo et al. (2002)). This illustrates the hidden relation between finitely effective debt constraints and collateral requirements.
ISSN:0304-4068
1873-1538
DOI:10.1016/j.jmateco.2011.09.006