Wednesday, May 13, 2015

Self-fulfilling Fire Sales: Fragility of Collateralised Short-term Debt Markets

KUONG John
Read the working paper
INSEAD Working Paper 2015/37/FIN revised version of 2015/07/FIN

This paper shows that collateralised short-term debt, although privately optimal for reducing borrowers’ moral hazard, can cause fragility (multiple equilibria) when the collateral market is illiquid. A new form of coordination failure between borrowers’ ex ante margin and risk-taking decisions engenders a systemic run in the collateralised debt market: large changes in credit rationing, margins, repo spreads, etc. The model also captures the large (small) crosssectional differences between safe and risky collateral in bad (good) times. Finally, I show that asset price guarantees could improve welfare and promote stability but repealing repo contracts’ “automatic stay” exemption might do the opposite.