Bubbles and limited liability

What is it about?

It is often claimed that excess of leverage can lead to bubbles due to asset substitution. We show that asset substitution alone cannot cause bubbles because it is priced into the intermediaries׳ securities. But incomplete contracts and managerial agency problems can make intermediaries take excessive risk to exploit limited liability, bidding up risky asset prices.

Featured Image

Why is it important?

First, our model predicts what kinds of assets will be prone to bubbles. Second, our model provides a potential explanation for why riskier assets can have too low risk premiums relative to their risk. Third, our theory also offers interpretations of the causes and consequences of financial crises.

Perspectives