Asset Pricing and Bank Lending Equilibrium with Collateral--university of Melb preserntation.dvi

While much of the existing financial literature on asset pricing and corporate finance assumes an exogenous lending market, this paper studies an endogenous one in a general equilibrium model. To achieve this, a natural instrument is collateral, because its value is associated with the conditional liquidation price. In the economy, all agents are endowed with a collateralizable asset and cash, and some(entrepreneurs) also own private investments. This collateralizable asset can be traded or used as collateral to borrow from banks to finance private investments. The collateral value and amount of borrowing are endogenously determined by all agents’ wealth. This endogeneity allows the collateralizable asset price to be less sensitive to the change in the return on these private investments, due to the wealth effect of the private investments on the price, an effect that does not exist in an exogenous lending market. In addition, when entrepreneurs can choose among different private investments, banks facilitate diversification of these choices by subsidizing the less profitable ones. This subsidized loan theory has two advantages: to study explicitly the role of banks in the capital budgeting literature and to shed light on the empirical findings about the negative correlation between leverage and profitability. ∗Johnson Graduate School of Management, Cornell University, Ithaca, New York 14853. e-mail: [email protected].