Uninsured Risks, Loan Contracts and the Declining Equity Premium

Using a two period model with moral hazard and uninsured risk, we argue that the decline in equity premium from its historically high level is due to a gradual elimination of barriers to universal banking. The loan contracts set up by financial intermediaries became more complete in nature with the advent of universal banking in the 90s following the Gramm-Leach-Billy Act. Hence, it is the nature of the loan contracts, not just the borrowing constraint and uninsured risks that is more fundamental in explaining the size of the equity premium. Without implicating we gratefully acknowledge useful feedbacks from Elie Appelbaum, George Constantinides, Alessandra Guariglia, Les Reinhorn, Simon Vicary, and the seminar participants of Birbeck College London, Canadian Economic Association conference at Toronto, the Equity Premium Conference at the University of Exeter, University of Manchester and York University. Special thanks go to John Donaldson and Rajnish Mehra for their detailed comments. Any remaining errors are our responsibilities.