DP15757 Financial Fragility with Collateral Circulation

Author(s): Piero Gottardi, Vincent Maurin, Cyril Monnet
Publication Date: February 2021
Keyword(s): Collateral, Credit chains, fragility, intermediation, Secured Lending
JEL(s): G23, G30
Programme Areas: Financial Economics, Industrial Organization, International Macroeconomics and Finance, Macroeconomics and Growth
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=15757

We present a model of secured credit chains in which the circulation of risky collateral generates fragility. An intermediary stands between a borrower and a financier. The intermediary borrows to finance her own investment opportunity, subject to a moral hazard problem, and in addition, can intermediate funds. She will only do so if she can repledge to the financier the collateral pledged by the borrower. We show that when the repledged collateral is sufficiently risky and the loan that it secures is recourse, the circulation of collateral generates fragility in the chain, by undermining the intermediary's incentives. The arrival of news about the value of the repledged collateral further increases fragility. This fragility channel of collateral re-use generates a premium for safe or opaque collateral. The environment considered in our model applies to various situations, such as trade credit chains, securitization and repo markets.