Collateralization, Leverage, and Stressed Expected Loss

63 Pages Posted: 12 Aug 2015

See all articles by Eric Jondeau

Eric Jondeau

University of Lausanne - Faculty of Business and Economics (HEC Lausanne); Swiss Finance Institute

Amir Khalilzadeh

Swiss Finance Institute @ EPFL

Date Written: August 10, 2015

Abstract

We describe a general equilibrium model with a banking system in which the deposit bank collects deposits from households and the merchant bank provides funds to firms. Merchant banks borrow collateralized short-term funds from deposit banks. In a financial downturn, as the value of collateral decreases, the merchant bank must sell assets on short notice, reinforcing the crisis, and default if their cash buffer is insufficient. The deposit bank suffers from loss because of the depreciated assets. If the value of the deposit bank’s assets is insufficient to cover deposits, it also defaults. Deposits are insured by the government. The premium paid by the deposit bank is its expected loss on the deposits. We define the bank’s capital shortfall in the crisis as the expected loss on deposits under stress. We calibrate the model on the U.S. economy and show how this measure of stressed expected loss behaves. In the absence of regulation, a 40% decline of the securities market would induce a loss of 17.8% in the ex-ante value of the assets or 80.7% of the ex-ante value of the equity.

Keywords: Real business cycle model, Capital shortfall, Systemic risk, Collateral, Leverage

JEL Classification: D5, E2, E32, E44, G2

Suggested Citation

Jondeau, Eric and Khalilzadeh, Amir, Collateralization, Leverage, and Stressed Expected Loss (August 10, 2015). Swiss Finance Institute Research Paper No. 15-24. Available at SSRN: https://ssrn.com/abstract=2641769 or http://dx.doi.org/10.2139/ssrn.2641769

Eric Jondeau (Contact Author)

University of Lausanne - Faculty of Business and Economics (HEC Lausanne) ( email )

Extranef 232
Lausanne, 1012
Switzerland
+41 21 692 33 49 (Phone)

HOME PAGE: http://www.hec.unil.ch/ejondeau/

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Amir Khalilzadeh

Swiss Finance Institute @ EPFL ( email )

UNIL Chamberonne
Ext 248
1015 Lausanne, CH-1015
Switzerland

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