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FIIT-4: Collateral and market fragility
The Opportunity Cost of Collateral
1Washington University in St Louis, United States of America; 2Columbia Business School, USA
We develop a dynamic model of borrowing and lending in the interbank market in which banks fund investments through short-term collateralized debt, like repos. This debt is not a perfect substitute for cash: lending banks may not be able to convert their loans to cash to fund their own investments. Hence, lending comes with an opportunity cost that generates positive spreads even absent any credit risk. These spreads enter banks’ collateral constraints, generating a two-way feedback between the opportunity cost in the credit market and the price of collateral in the asset market. This feedback results in instability in the form of multiple equilibria, casting light on repo runs. It highlights the unique fragility present in the bilateral repo market, in which banks borrow from one another, but not in the tri-party repo market, in which banks borrow from passive cash investors, who do not suffer the opportunity cost. We show that high-leverage equilibria are inefficient in booms; hence, the model suggests a new rationale for counter-cyclical capital regulation: to select the efficient equilibrium.
Federal Reserve Board, United States of America
This paper models an unexplored source of liquidity risk faced by large broker-dealers: collateral runs. By setting different contracting terms on repurchase agreements with cash borrowers and lenders, dealers can source funds for their own activities. Cash borrowers internalize the risk of losing their collateral in case their dealer defaults, prompting them to withdraw it. This incentive creates strategic complementarities for counterparties to withdraw their collateral, reducing a dealer's liquidity position and compromising her solvency. Collateral runs are markedly different than traditional wholesale funding runs because they are triggered by a contraction in dealers' assets, and thus mitigating these risks involve different policy recommendations.
Dynamic Asset-Backed Security Design
1London School of Economics, United Kingdom; 2London Business School
We study a dynamic problem of the design and sale of securities backed by a long-lived collateral asset. Issuers are privately informed about the quality of the asset, and raise capital by securitizing it. Issuers can pledge not only the current period payoff from the assets, but also the future resale price. There is a dynamic feedback loop between the future asset price and today’s collateral quality: An asset that is a good (lousy) collateral has high (low) resale price, but high (low) resale price makes an asset a good (lousy) collateral. Multiple dynamic - liquid and illiquid - equilibria might arise when only equity contracts can be issued. We characterize the optimal security design and demonstrate that it involves short-term liquid collateralized debt. It eliminates the multiple equilibria fragility and improves social welfare relative to the illiquid equity equilibrium. When security contract is not flexible, runs might occur through the dynamic feedback loop. Comparative statics generate rich dynamic properties of haircuts and interest rates as well as runs in relation to adverse selection and default risk.
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