Collateralization, Leverage, and Stressed Expected Loss

44 Pages Posted: 6 Oct 2015 Last revised: 15 Feb 2017

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: January 18, 2017

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. The merchant bank borrows collateralized short-term funds from the deposit bank. In an economic downturn, as the value of collateral decreases, the merchant bank must sell assets on short notice, reinforcing the crisis, and defaults if its cash buffer is insufficient. The deposit bank suffers from losses 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, with a premium paid by the deposit bank equal to 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 for different calibrations of the model. A 40% decline of the securities market would induce a loss of 12.5% in the ex-ante value of deposits.

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

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

Suggested Citation

Jondeau, Eric and Khalilzadeh, Amir, Collateralization, Leverage, and Stressed Expected Loss (January 18, 2017). Journal of Financial Stability, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2669455 or http://dx.doi.org/10.2139/ssrn.2669455

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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