The Collateral Trap

39 Pages Posted: 7 Jun 2016

See all articles by Frédéric Boissay

Frédéric Boissay

Bank for International Settlements (BIS)

Russell Cooper

University of Texas at Austin - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: June 2016

Abstract

Active wholesale financial markets help reallocate deposits across heterogeneous banks. Because of incentive problems, these flows are constrained and collateral is needed. Both the volume, the value, and the composition of collateral matter. We make a distinction between "outside collateral" and "inside collateral". The use of inside assets, such as loans, creates a "collateral pyramid", in that cash flows from one loan can be pledged to secure another. Through collateral pyramids the financial sector creates safe assets, but at the cost of exposing the economy to systemic panics. Outside collateral, such as treasuries, serves as foundation of, and stabilises, the pyramid. There is a threshold for the volume of treasuries, below which investors panic, the pyramid collapses, and there is not enough safe assets to support wholesale market activity; a situation that we call "collateral trap".

Keywords: Banking crisis, collateral composition

JEL Classification: G01, G21

Suggested Citation

Boissay, Frédéric and Cooper, Russell W., The Collateral Trap (June 2016). BIS Working Paper No. 565. Available at SSRN: https://ssrn.com/abstract=2789739

Frédéric Boissay (Contact Author)

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

Russell W. Cooper

University of Texas at Austin - Department of Economics ( email )

Austin, TX 78712
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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