DP15757 Financial Fragility with Collateral Circulation
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.