Savings and default (Q372376)

The optimal contract traded in complete markets is shown to be free of default. However, in an incomplete market, the optimal credit contract allows for the possibility of default. In this case, a precautionary savings motive is very common and liquid wealth is intimately connected with default. In this paper, the authors study the relation between liquid storage and default. The authors propose a model where two types of agents try to insure against future idiosyncratic risk in their endowment and also smooth their intertemporal consumption. They can either trade in a competitive bond market, where credit risk is present, or store some of their current endowment for future consumption. The model in this article is a two-period one with two types of agents which know the present but face an uncertain future. The agents trade a single storable consumable commodity and a bond with a pay-off normalized to 1 at the second period. Subject to the budget constraints, at the beginning, agents consume the commodity, trade the bond and make a precautionary saving. In the second period, the agents consume the commodities traded and bonds are due with agents choosing how much to deliver on their debt. An expected utility is constructed for each two-period strategy. The goal for each agent is to choose a strategy to maximize its expected utility. In fact, this turns into a constraint optimization problem. The authors show that under an appropriate market structure, the amount of storage increases the delivery rate on bonds such that the trade and welfare improve and also when a credit market is inactive, the imposition of a minimum level of storage will improve the beliefs of creditors to a point where the offer price is sufficiently attractive for debtors to accept and reactivate the bond market. Hence, the saving requirements above the precautionary savings increase the trade and result in a constrained efficient equilibrium. Moreover, the authors point out that the savings requirements to agents usually can be achieved through regulation to store a higher proportion of their current endowment when there is a high risk of future default and this default probably leads to the collapse of the credit markets.