Collateral Quality and Intervention Traps

Abstract

What determines the supply of good collateral? We study a dynamic model in which borrowers must exert effort to maintain collateral quality and markets become illiquid when average quality is too low. Average quality grows quickly when it is high initially, but deteriorates or grows slowly otherwise. As such, even long-run market conditions are sensitive to a wide array of fundamental and non-fundamental shocks. Recoveries from illiquidity can occur, but only if funding is inefficiently rationed for some time. Policymakers without commitment may fall into intervention traps in which ex-post efficient liquidity injections cause permanent declines in collateral quality.

Keywords: Collateral, Liquidity, Financial Regulation, Financial Intermediation, Adverse Selection, Moral Hazard, Financial Crises

JEL Classification: G01, G21, G28