The Limits of Market Discipline: Proprietary Trading and Aggregate Risk†

This paper studies the impact of external claim-holders heterogeneity on entrepreneurial risk-taking. We show that risk-taking by entrepreneurs and demand for risky securities by risk-neutral traders (e.g. fund managers or proprietary traders) are mutually reinforcing. Market discipline is the mechanism by which the adjustment of cost of capital to the level of risk feeds into managerial incentives and deters excessive risk-taking. Larger risk-neutral traders (relative to risk-averse investors) not only undermine market discipline and lead to more risk-taking, but they also benefit more from the upside of risk and become relatively larger if the project pays out, which leads to even more risk-taking in the next period. The model explains documented features of the business cycle: bubble-like asset prices (procyclical run-up in prices and procyclical underpricing of risk), shorter cycles and countercyclical leverage of the non-financial sector. We extend the model to allow riskneutral traders to raise external financing and show that the endogenous procylical leverage of risk-neutral traders can lead to additional aggregate volatility. * Rady School of Management, University of California, San Diego and Imperial College Business School, London. Email: [email protected]. † I am grateful to Thomas Baranga and Konstantin Milbradt and seminar participants at ESSEC for helpful comments. 1