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INSEAD Working Paper 2015/07/FIN
This paper shows that collateralised short-term debt, although optimal to reduce borrower moral hazard, can lead to systemic runs in the debt markets and create endogenous aggregate risk. This is because of a feedback loop between the risk-taking behavior of borrowers (e.g. shadow banks) and the expected price of seized collateral in the secondary market. When the re-sale price of collateral is expected to be low, lenders demand more collateral (margin) and higher debt yields (repo rates), making it more attractive for borrowers to engage in risk-taking ex-ante (due to limited liability). The riskier pool of projects will lead to more liquidation ex-post and hence more seized collateral to be sold off, justifying the expectation of low fire-sale price. I show that a government commitment to engage in asset purchases in a crisis can improve welfare, and that a ban on the exemption from automatic stay in repo nance can worsen borrower moral hazard and lead to more re sales.