Margining and the Stability of the Banking Sector
53 Pages Posted: 9 Dec 2008 Last revised: 3 Jan 2011
Date Written: October 1, 2008
We investigate the effects of margining, a widely-used mechanism to attach collateral to derivatives contracts, on derivatives’ trading volume, default risk, and on the welfare in the banking sector. First, we develop a stylized banking sector equilibrium model to derive a set of testable hypotheses. Subsequently, we test these hypotheses with a simulation model that captures some of the essential characteristics of over-the-counter derivatives markets. Contrarily to the common belief that margining always reduces default risk, we find that there exist situations in which margining increases default risk, reduces aggregate derivatives’ trading volume, and has an ambiguous effect on welfare in the banking sector. The negative effects of margining are exacerbated during periods of market stress when margin rates are high and collateral is scarce. We also find that central counterparties only lift some of the inefficiencies caused by margining.
Keywords: Derivative Securities, Default Risk, Collateral, Margining, Systemic Risk
JEL Classification: G19, G21
Suggested Citation: Suggested Citation