Financial Instability with Circulating Debt Claims and Endogenous Debt Limits

The issuance of circulating liabilities, together with endogenous debt limits, gives rise to a franchise value for intermediaries. A competitive equilibrium with endogenous debt limits admits allocations that are characterized by a funding crisis and a self-fulfilling collapse of the banking system, with the intermediary’s franchise value eroding over time. In view of these difficulties, I construct a sophisticated fiscal policy that provides a government guarantee for the franchise value, which results in the determinacy of equilibrium, with the constrained efficient allocation emerging as the unique outcome.