Working Paper: NBER ID: w20703
Authors: Frdric Boissay; Russell Cooper
Abstract: Active wholesale financial markets help reallocate deposits across heterogeneous banks. Because of incentive problems these flows are constrained and collateral is needed. The composition of collateral matters. The use of inside assets (loans) creates a “collateral pyramid” in that cash flows from one loan can be pledged to secure another. Through collateral pyramids the financial sector creates safe assets, but at the cost of exposing the economy to systemic panics. Outside collateral (treasuries) serves as foundation of, and stabilises, the pyramid. There is a threshold for the volume of treasuries, below which investors panic and the pyramid collapses.
Keywords: collateral; financial markets; systemic risk; interbank markets
JEL Codes: E44; E51; G21; G23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| inside collateral (O36) | less stable market environment (G19) |
| inside assets (loans) (G21) | collateral pyramid (G32) |
| collateral pyramid (G32) | systemic panics (E44) |
| limited access to outside collateral (G33) | tighter borrowing constraints (F65) |
| tighter borrowing constraints (F65) | reduced interbank activity (E44) |
| reduced interbank activity (E44) | resource misallocation (D61) |
| resource misallocation (D61) | economic recession (F44) |
| collateral trap (F65) | lower interbank activity (E44) |
| lower interbank activity (E44) | less efficient allocation of resources (D61) |
| collateral trap (F65) | equilibrium interbank rate decreases (E43) |