Self-Fulfilling Fire Sales: Fragility of Collateralised Short-Term Debt Markets
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
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