Optimal Financial Structure and Asset Prices

Abstract

I study the welfare properties of competitive equilibria in an economy with financial frictions. In the model, entrepreneurs raise funds to set up a firm, then they exert effort, and finally they trade assets. Private financial contracts do not internalize their impact on asset prices. On the one hand, lower prices depress firms' liquidation value, which reduces the pledgeable income the collateral effect. On the other hand, lower prices boost entrepreneurs' incentives to achieve good performance, which alleviates the moral hazard problem and raises the pledgeable income the incentive effect. I show that the latter effect outweighs the former, implying that a decrease in asset prices improves welfare. Even though, from a first-best perspective the competitive equilibrium displays too low asset prices, from a second-best point of view prices are too high.