Moral Hazard and the Balance Sheet Channel

I build a model of balance sheet recessions where financial frictions are derived from a moral hazard problem. I show that TFP shocks are amplified through a balance sheet channel only if the private action of the agent exposes him to aggregate risk through his private benefit. This creates a tradeoff between idiosyncratic and aggregate risk-sharing. More productive agents want to leverage more and hence face more idiosyncratic risk. They therefore take a relatively larger fraction of aggregate risk in order to relax their idiosyncratic risk-sharing problem. After a negative aggregate shock their net worth falls, driving asset prices, growth, and output down. In contrast, under the standard moral hazard setup, optimal contracts separate aggregate risk-sharing from incentives, and the balance sheet channel completely disappears.