Borrowing Constraints Research Articles

Life insurance demand and borrowing constraints

AbstractThe literature devoted limited attention to exploring the relationship between financial development and life insurance demand. Financial development supports life insurance supply by providing confidence in the financial system, more efficient payment systems, and higher availability of financial instruments. However, financial development reduces households' needs to save by relaxing borrowing constraints, indirectly affecting life insurance demand. We contribute by providing a demand‐driven explanation of the negative consequences of financial development on life insurance development. We find that more credit‐constrained countries have higher life insurance penetration on average. Indirectly, the role of borrowing constraints signifies the importance of life insurance policies as a financing tool in case of the realization of various background risks. This study integrates the knowledge from life insurance theory, life insurance lapse, policy loans demand, and saving under liquidity constraints literature and produces implications for researchers, policymakers, and life insurers.

Reference‐dependent preferences, time inconsistency, and pay‐as‐you‐go pensions

AbstractThe classic Aaron–Samuelson result argues that pay‐as‐you‐go (PAYG) pension schemes cannot coexist with higher‐return, private, retirement‐saving schemes. The ensuing literature shows if agents voluntarily undersave for retirement due to myopia or time‐inconsistency, then a paternalistic, rationale for PAYG pensions arises only if voluntary retirement saving is fully crowded out because of a binding borrowing constraint. This paper generalizes the discussion to the reference‐dependent utility setup of Kőszegi and Rabin (2009) where undersaving happens naturally. No borrowing constraint is imposed. We show it is possible to offer a non‐paternalistic, welfare rationale for return‐dominated, PAYG pensions to coexist with private, retirement saving.

Dynamic Asset Pricing with Interactions between Short-Sale and Borrowing Constraints

Abstract This paper studies the joint effect of borrowing and short-sale constraints under heterogeneous beliefs and risk aversions. Although the constraints never simultaneously bind in equilibrium, interesting economics emerge in the anticipatory effects of potentially future binding constraints. In particular, the risk-free rate and Sharpe ratio experience endogenous jumps at a critical state, where two equilibria coexist. Moreover, a short-sale ban can lead to a lower stock price and higher volatility depending on the relative tightness between the constraints, and tightening the borrowing constraint during a short-sale ban can also make returns more volatile. (JEL G11, G12)

Environmental policies with financing constraints in China

We study how borrowing constraints and environmental policies jointly exert their effects on the pollution emission level of China's enterprises using a New Keynesian approach. We consider three environmental policy alternatives: the emission tax policy, the intensity target policy, and the emission cap policy. We consider shocks to the borrowing constraints, the different policies, and the monetary policy and plot the impulse-response of environmental and economic variables following the above shocks. We also do comparative statics using two scenarios of borrowing constraints. We find significant effects of borrowing constraints on the efficacy of environmental and monetary policies, pointing out the importance of weighing in the borrowing constraints when analyzing environmental protection from an economic angle in China.

Maximizing the goal-reaching probability before drawdown with borrowing constraint

<abstract> We study the optimal investment problem in a constrained financial market,where the proportion of borrowed amount to the current wealth level is no more than a given constant. The objective is to maximize the goal-reaching probability before drawdown,namely,the probability that the value of the wealth process reaches the safe level before hitting a lower dynamic barrier. The financial market consists of a risk-free asset and multiple risky assets. By the construction of auxiliary market and convex analysis,we relax the borrowing constraint and investigate the new optimization problem in an auxiliary market,where there is no such borrowing constraint. Then,we find the relationship between the optimal results in auxiliary market and those in constrained market. The explicit expressions for the optimal investment strategy and the maximum goal-reaching probability before drawdown are derived in closed-form. Finally,we provide some numerical examples to show the effect of model parameters on the behaviors of investor. </abstract>

Time Aggregation in Health Insurance Deductibles

Health insurance plans increasingly pay for expenses only beyond a large annual deductible. This paper explores the implications of deductibles that reset over shorter timespans. We develop a model of insurance demand between two actuarially equivalent deductible policies, in which one deductible is larger and resets annually and the other deductible is smaller and resets biannually. Our model incorporates borrowing constraints, moral hazard, mid-year contract switching, and delayable care. Calibrations using claims data show that the liquidity benefits of resetting deductibles can generate welfare gains of 6-10% of premium costs, particularly for individuals with borrowing constraints.

Optimal Portfolio Choice With Path-Dependent Labor Income: Finite Retirement Time

This paper extends the project initiated in and studies a lifecycle portfolio choice problem with borrowing constraints and finite retirement time in which an agent receives labor income that adjusts to financial market shocks in a path dependent way. The novelty here, with respect to, is the fact that we have a finite retirement time, which makes the model more realistic, but harder to solve. The presence of both path-dependency, as in, and finite retirement, leads to a two-stage infinite dimensional stochastic optimal control problem, a family of problems which, to our knowledge, has not yet been treated in the literature. We solve the problem completely, and find explicitly the optimal controls in feedback form. This is possible because we are able to find an explicit solution to the associated infinite dimensional Hamilton-Jacobi-Bellman (HJB) equation, even if state constraints are present. Note that, differently from, here the HJB equation is of parabolic type, hence the work to identify the solutions and optimal feedbacks is more delicate, as it involves, in particular, time-dependent state constraints, which, as far as we know, have not yet been treated in the infinite dimensional literature. The explicit solution allows us to study the properties of optimal strategies and discuss their financial implications.

The consumption response to borrowing constraints in the mortgage market

This paper shows that relaxing borrowing constraints positively affects household consumption in addition to stimulating housing market activity. We focus on the UK Help-to-Buy (HTB) program, which provided a sudden relaxation of the down payment constraint by facilitating home purchases with only a five percent down payment. Our research design exploits geographic variation in exposure to HTB and uses administrative data on mortgages and car sales in combination with household survey data. We estimate that the program increased total home purchases by 11 percent, and the increase was driven almost entirely by first-time and young buyers. Regions that were more exposed to the program experienced a rise in non-durable consumption unrelated to the home and in loan-financed car purchases, in addition to an increase in home-related expenditures. These results are independent of changes in regional house prices. Our findings point to a further link between the housing market and household consumption that does not operate through the home purchase and housing wealth channels.

Equity Home Bias When Firms are Indebted

We reassess one of the major puzzles in international macroeconomics, namely the equity home bias puzzle, to shed some light on how it is affected by financial leverage. As corporate debt is generally key to employment, the analysis can provide interesting insights to the mooted argument according to which equity home bias stems from agents’ attempt to insure against changes in their labor income. In a panel of advanced economies spanning the period 1980 through 2018, we find that the non-financial corporate credit-to-GDP ratio is negatively correlated with a standard equity home bias index. The former has increased over time while the latter has decreased, so we attempt to rationalize the data with a two-country, two-good model where firms face borrowing constraints and these constraints reduce agents’ appetite for domestic equities. We show that this happens because the borrowing constraints hinder employment after positive technology shocks, especially those hitting investment. After examining this result with a tractable framework, we find that it can also be true in an extended model, adding financial shocks, trade in bonds and non-unitary elasticity of substitution between goods.

Land Price Dynamics and Macroeconomic Fluctuations with Imperfect Substitution in Real Estate Markets

The collateral channel, whereby an increase in residential house prices leads to an increase in commercial property prices, loosening firm borrowing constraints and increasing firm investment, is weaker when residential and commercial real estate are imperfect substitutes. We enrich the DSGE model of the collateral channel in Liu, Wang, and Zha (2013) by adding a land development sector to allow residential and commercial land to be imperfect substitutes. Bayesian estimation of our structural model based on aggregate U.S. data indicates imperfect substitution between the two types of land. With variance decompositions and impulse responses, we show that the strength of the collateral channel linking residential house prices and firm investment is weaker when the two types of land are imperfect substitutes. When residential and commercial land are assumed to be perfect substitutes, shocks to residential real estate demand explain 20-30% of the variance of total output and 30-40% of the total investment, but with the imperfect degree of substitution that we estimate, the same shocks explain less than 10% of the variance of output and 12-15% of investment.

Banking Access and Racial Inequality: Wealth and Human Capital Accumulation of Young Men

There are large racial differences in access to the financial system among young adults. Lack of access to savings and investment opportunities results in low financial returns on savings. Low returns, in turn, reduce ex-ante incentives to save, work, and invest in human capital. Using a structural model of schooling, labor supply, and savings with unequal financial access and endogenous borrowing constraints, I quantify the effects of racial differences in financial access and labor market discrimination on the observed racial wealth gap. Counterfactual policy experiments suggest that a financial inclusion policy that provides full access increases African American youths’ median net worth level and reduces racial wealth inequality. In comparison, a college tuition reduction policy is less effective in reducing wealth inequality.

Macroprudential Policy Interlinkages

Emerging markets are concerned about sudden stops in international capital flows, which may lead to severe recessions associated with vicious spirals of currency depreciations and tightening borrowing constraints. A common prescription is to impose macroprudential policies, including prudential capital controls, to limit international borrowing especially in foreign currency. This paper analyzes the supportive role of macroprudential policies geared toward the domestic financial market, suggesting that emerging markets should resort to a wide mix of policies, even when the domestic financial market is frictionless. A simple formula provides further insights: domestic and international macroprudential policies are imperfect complements rather than substitutes, due to distinctive characteristics of foreign and domestic currency bonds. Furthermore, the relative importance of domestic macroprudential regulation increases in the return of domestic bonds.

Land Price Dynamics and Macroeconomic Fluctuations with Imperfect Substitution in Real Estate Markets

The collateral channel, whereby an increase in residential house prices leads to an increase in commercial property prices, loosening firm borrowing constraints and leading to higher firm investment, is weaker when residential and commercial real estate are imperfect substitutes. We first show in a reduced form regression with firm level data that the strength of local zoning regulations has a negative effect on the estimated increase in firm investment following an increase in local residential real estate prices. We then modify the DSGE model of the collateral channel in Liu, Wang, and Zha (2013) to allow imperfect substitutability between residential and commercial land. With Bayesian estimation and U.S. data, we estimate that the elasticity of substitution between the two types of land is 0.88. Variance decompositions and impulse responses show that the strength of the collateral channel linking house prices and investment is weaker when the two types of land are imperfect substitutes

Contestable Credit Markets and Household Welfare: Panel Data Evidence from Ethiopia

This paper explores the impact of credit constraints on household welfare in Ethiopia. We use a three-wave panel dataset for rural and small-town households to estimate the effects of household borrowing constraints on two alternative indicators of household welfare: consumption expenditure and asset ownership. The presence of a constraint is treated as an endogenous regressor, using an instrumental variable based on Baumol’s theory of contestable markets. We find that credit constraints have a significantly negative effect on both outcomes. These results are robust to several alternative specifications of the model.

Optimal Retirement Problem Under Partial Information

The optimal retirement decision is an optimal stopping problem when retirement is irreversible. We investigate the optimal consumption, investment, and retirement decisions when the mean return of a risky asset is unobservable and is estimated by filtering from historical prices. To ensure non-negativity of the consumption rate and the borrowing constraints on the wealth process of the representative agent, we conduct our analysis using a duality approach. We link the dual problem to American option pricing with stochastic volatility and prove that the duality gap is closed. We then apply our theory to a hidden Markov model for regime-switching mean return with Bayesian learning or the Wonham filter. We fully characterize the existence and uniqueness of variational inequality in the dual optimal stopping problem, as well as the free boundary of the problem. An asymptotic closed-form solution is derived for optimal retirement timing by small-scale perturbation. We discuss the potential applications of the results to other partial information settings.

Housing affordability, borrowing constraints and tenure choice in Korea

ABSTRACT This paper analyses the linkages between housing affordability and borrowing constraints, and the impact of the latter on housing tenure decisions in Korean cities during the period 2006–2016. The conventional aggregate measures of housing affordability provide a mixed picture. The price to income ratio (PIR) increased in major cities but the home purchase affordability, or repayment affordability improved between 2006 and 2016. Also, the access to mortgage finance increased substantially thanks to the expansion of mortgage supply, low interest rates and lenient macroprudential regulations. We investigate whether and how these changes affected household home purchases using the household-level micro data from the 2006 and 2016 Korea Housing Surveys. We construct the variable indicating the degree of borrowing constraint in terms of wealth each household faces and show that the number of borrowing-constrained households dropped significantly between 2006 and 2016. We then investigate the effect of the wealth constraint by including a measure of the degree of the borrowing constraint as an explanatory variable in the tenure choice equation, together with other key variables such as the cost of owning relative to renting. Estimation results confirm that, as expected, the propensity to home purchases declines if households are judged as wealth-constrained. It was also found that the detrimental effect of the wealth constraint on home ownership increased significantly, particularly for severely constrained households, while the homeownership rates for others improved during our study period. Our findings suggest that affordability measures that do not consider borrowing constraints may not be very helpful in gauging affordability of home purchases at the household level.

Investment and financing decisions with learning-curve technology

The learning curve has a significant impact on production cost (hence corporate profit) in a number of industries. While the learning curve is well recognized in the Economics literature and its effect on operating costs and production decisions widely studied, its effect on corporate investment has been largely unexplored. To our knowledge, there is one paper that examines this issue, but it is limited to unlevered firms. We therefore examine a levered firm's optimal investment and financing choices when using learning-curve technology. The main findings are as follows. The effect of leverage on the investment decision depends on the level of debt. Using the optimal debt level will result in earlier and larger investment. Thus, leverage has a positive effect on investment overall, and the difference between levered and unlevered firm is an increasing function of learning speed. The optimal leverage ratio (without a borrowing constraint) is an increasing function of learning speed. With a borrowing constraint, the investment decision is similar to the unconstrained-borrowing case, but the leverage ratio is initially increasing and subsequently decreasing in learning speed. Moreover, it is a decreasing function over a wider range for a more stringent borrowing constraint, for decreasing-returns-to-scale technology and for a less volatile product market.

Anatomy of Corporate Borrowing Constraints*

Abstract Macro-finance analyses commonly link firms’ borrowing constraints to the liquidation value of physical assets. For U.S. nonfinancial firms, we show that 20% of debt by value is based on such assets (asset-based lending in creditor parlance), whereas 80% is based predominantly on cash flows from firms’ operations (cash flow–based lending). A standard borrowing constraint restricts total debt as a function of cash flows measured using operating earnings (earnings-based borrowing constraints). These features shape firm outcomes on the margin: first, cash flows in the form of operating earnings can directly relax borrowing constraints; second, firms are less vulnerable to collateral damage from asset price declines, and fire sale amplification may be mitigated. Taken together, our findings point to new venues for modeling firms’ borrowing constraints in macro-finance studies.

Housing prices and trade surpluses in China: An inter-temporal approach

This paper develops an inter-temporal current account model to study the impacts of expected rising housing prices on trade surpluses in China. The model shows two channels working in opposite directions. The first channel is the intra-temporal substitution channel. It discourages current consumption of tradable goods, leading to trade surpluses. The second is the inter-temporal substitution channel, which instead leads to trade deficits. When intra-temporal channel dominates, expected rising housing prices lead to trade surpluses. However, borrowing constraints on housing purchases may weaken the intra-temporal substitution channel and thus weaken the positive correlation between expected housing prices and trade surpluses. We show empirically that expected rising housing prices lead to trade surpluses in China. We also identify possible reason for this finding: strong intra-temporal substitution elasticity due to large male to female sex ratio in China. We further show that the positive relation between expected rising housing prices and trade surpluses is weaker in regions with more stringent borrowing constraints, consistent with our model’s prediction.

Financial Integration, Savings Gluts, and Asset Price Booms

AbstractCapital outflows after financial integration can lead to simultaneous increases in the national savings rate and asset prices of an economy with substantial financing costs. Under autarky, firms invest in risky capital while facing a borrowing constraint that creates a need for precautionary savings. Financial integration provides firms with access to foreign risk-free assets and results in two effects: a substitution effect, whereby firms divert some investments to foreign assets and cause capital outflows; and a wealth effect, whereby they grow richer in equilibrium and thus demand more domestic capital. Savings gluts and asset price booms occur when the wealth effect dominates.