Prudential Policy with Debt Overhang

Modern macroeconomy experienced recurrent financial crises followed by protracted periods of debt overhang and slow recovery. This paper proposes a tractable dynamic framework in which debt accumulated during credit booms is sufficiently large that corporate entities cannot attract voluntary new lending during a crisis. We study the efficiency properties and show that firms’ individually optimal investment decisions during credit booms fail to internalize their collective effect in exacerbating economy-wide debt overhang during recessions. Stabilization policies such as debt bailouts make the economy more crisis-prone, whereas market-based monetary stimulus discourages ex ante risk taking. Numerical illustrations suggest that optimally designed prudential policy substantially mitigates the incidence, severity, and protractedness of financial crises.