Consumer Default with Complete Markets: Default-based Pricing and Finite Punishment

Xavier Mateos-Planas and Giulio Seccia
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Xavier Mateos-Planas: Queen Mary University of London
Giulio Seccia: University of Southampton

No 711, Working Papers from Queen Mary University of London, School of Economics and Finance

Abstract: This paper studies economies with complete markets where there is positive default on consumer debt. In a simple tractable two-period model, households can default partially, at a finite punishment cost, and competitive intermediaries price loans of different sizes separately. This environment yields only partial insurance. The default-based pricing of debt makes it too costly for the borrower to achieve full insurance and there is too little trade in securities. This framework is in contrast with existing literature. Unlike the literature with default, there are no restrictions on the set of state contingent securities that are issued. Unlike the literature on lack of commitment, limited trade arises without need of debt constraints that rule default out. Compared with the latter, the present approach appears to imply more consumption inequality. An extended model with an infinite horizon, idiosyncratic risk and more realistic assumptions is used to demonstrate the general validity of this approach and its main implications.

Keywords: Consumer default; Complete markets; Endogenous incomplete markets; Risk-based pricing; Risk sharing (search for similar items in EconPapers)
JEL-codes: D52 E21 E44 (search for similar items in EconPapers)
Date: 2013-11-01
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Citations: View citations in EconPapers (1)

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