Risk Sharing, (Over)Leverage, and Regulation

The paper examines the leverage of …nancial intermediaries in a general equilibrium framework. The paper’s approach is driven by risk sharing and captures two features: Debt serves to boost the return of equity and equity to "safe net" debt. The paper …nds that if entrepreneurs cannot obtain cheaper credit from …nancial intermediaries by reducing the investment scales, the equilibrium leverage rate is above the social best one, while if they can, the two rates coincide. In the latter case, the credit market is cleared not by price, but by contract which speci…es both the price and the scale. The paper argues that overleverage is more likely to occur where small and middle sized …rms are more dominant, and shows that it can be recti…ed by proper capital adequacy regulation.