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

45 Pages Posted: 8 Oct 2014 Last revised: 13 May 2015

John Chi-Fong Kuong

INSEAD - Finance

Date Written: April 2015

Abstract

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

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

John Chi-Fong Kuong (Contact Author)

INSEAD - Finance ( email )

Boulevard de Constance
77305 Fontainebleau Cedex
France

HOME PAGE: http://www.johncfkuong.com

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