45 Pages Posted: 8 Oct 2014 Last revised: 13 May 2015
Date Written: April 2015
This paper shows that collateralised short-term debt, although privately optimal for reducing borrowers’ moral hazard, can cause fragility (multiple equilibria) when the collateral market is illiquid. A new form of coordination failure between borrowers’ ex ante margin and risk-taking decisions engenders a systemic run in the collateralised debt market: large changes in credit rationing, margins, repo spreads, etc. The model also captures the large (small) crosssectional differences between safe and risky collateral in bad (good) times. Finally, I show that asset price guarantees could improve welfare and promote stability but repealing repo contracts’ “automatic stay” exemption might do the opposite.
Keywords: Collateral, Self-fulfilling Fire sales, Repo run, Moral hazard, Optimal contract
Suggested Citation: Suggested Citation
Kuong, John Chi-Fong, Self-Fulfilling Fire Sales: Fragility of Collateralised Short-Term Debt Markets (April 2015). INSEAD Working Paper No. 2015/37/FIN. Available at SSRN: https://ssrn.com/abstract=2506661 or http://dx.doi.org/10.2139/ssrn.2506661
By Hongda Zhong