Collateral, Financial Intermediation, and the Distribution of Debt Capacity

We study whether borrowers optimally conserve debt capacity to take advantage of investment opportunities due to temporarily low asset prices, when financing is subject to collateral constraints due to limited enforcement. We find that borrowers may exhaust their debt capacity and thus may be unable to take advantage of such opportunities, even if they can arrange for loan commitments or contingent financing. The cost of conserving debt capacity is the opportunity cost of foregone investment. This opportunity cost is higher for borrowers with higher productivity and borrowers who are less well capitalized, and such borrowers are hence more likely to exhaust their debt capacity. Borrowers who exhaust their debt capacity may be forced to contract when cash flows are low, and hence capital may be less productively deployed then. Higher collateralizability may make the contraction more severe. We consider the role of financial intermediaries which are better able to collateralize claims, that is, are "securitization specialists," and study the dynamics of intermediary capital and spreads between intermediated and direct finance. When intermediary capital is scarce and spreads are high, borrowers who exhaust their debt capacity may be forced to contract by even more.