This thesis develops three models that study the motivation of various agents to take on debt,
and the impact that excessive financial leverage can have on social welfare.
In the chapter "Short-term Bank Leverage and the Value of Liquid Reserves", the incentive
of a bank to take on leverage stems from the fact that its short-term debt provides liquidity
benefits to depositors, at the cost of exposing the bank to the risk of runs. In the model, a
bank possesses two instruments to manage the risk of runs: its funding policy and the size of
its liquid asset holdings, modeled as government bonds. Issuing more debt allows the bank to
better capture the liquidity benefits fits priced into deposits but increases illiquidity risk. Holding
more bonds makes the bank more robust to withdrawals but it reduces the bank's asset returns.
When the supply is scarce, banks are the natural buyers of government bonds. This links the
liquidity premium priced into government bonds to the risk of bank runs.
In the chapter "Liquidity, Debt Overhang, and Monetary Policy", firms take on bank credit
to relax their liquidity constraint and purchase new capital. But taking on debt creates a
debt overhang distortion which causes entrepreneurs to pass on protable projects. In the
model, entrepreneurs arrange for their financing before they observe the profitability of their investment
opportunity. After the latter becomes known, entrepreneurs are liquidity-constrained
when investment conditions are favorable, and over-indebted when they are unfavorable. The
monetary authority can generate welfare gains by lowering the cost of holding liquidity and,
when debt is contracted in nominal terms, by pursuing a counter-cyclical monetary policy.
In the chapter "Safe Claim Production and Capital Structure", firms issue debt to satisfy the
demand of risk-averse investors for safe claims, at the cost of increasing default risk. In general
equilibrium, firms need to be compensated for this service, which can only occur if their debt and
equity claims are held and priced by different investor types. This segmentation of the investor
base can be sufficient to prevent the existence of a symmetric equilibrium. Instead, only a
fraction of firms opt for levered capital structures, and the gain in value obtained by tranching
cash flows into debt and equity is offset by the expected cost of default. Changes in aggregate
leverage can be divided into variations in extensive (the fraction of levered firms ) and intensive
(the leverage ratio of levered firms ) margins. Changes in rm business risk have opposite effects
on leverage, depending on whether the risk is of a systematic nature or firm-specific nature.