Working Paper: NBER ID: w20086
Authors: Weerachart T. Kilenthong; Robert M. Townsend
Abstract: This paper studies a competitive general equilibrium model with default and endogenous collateralized contracts. The possibility of trade in spot markets creates externalities, as spot prices and the bindingness of collateral constraints interact. We propose a market based solution which overcomes the externalities problem and obviates the needs for any government policy intervention. If agents are allowed to contract ex ante on market fundamentals determining the state-contingent spot prices used to unwind collateral, over and above contracting on true underlying states of the world, then standard existence and welfare theorems apply, that is, competitive equilibria are equivalent with Pareto optima.
Keywords: default; endogenous collateral; externalities; segregated exchanges; Walrasian equilibrium; limited commitment; financial crises
JEL Codes: D52; D53; D61; D62
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| interaction between spot prices and collateral constraints (G19) | creates externalities (D62) |
| creates externalities (D62) | inefficient equilibrium (D59) |
| ex ante contracts (D86) | market fundamentals (G10) |
| ex ante contracts (D86) | competitive equilibria equivalent to Pareto optima (D50) |
| market-based solution (D47) | internalizes the externality (D62) |
| internalizes the externality (D62) | valuation of collateral (G33) |
| valuation of collateral (G33) | decisions regarding default (G33) |
| segregated security exchanges (G10) | internalization of externalities (D62) |
| segregated security exchanges (G10) | missing markets (D52) |
| design of security markets (G10) | efficiency of collateral utilization (D61) |
| design of security markets (G10) | overall welfare of agents (I30) |