Re-Use of Collateral: Leverage, Volatility, and Welfare
31 Pages Posted: 7 Feb 2017
Date Written: February 6, 2017
We assess the quantitative implications of the re-use of collateral on financial market leverage, volatility, and welfare within an infinite-horizon asset-pricing model with heterogeneous agents. In our model, the ability of agents to re-use frees up collateral that can be used to back more transactions. Re-use thus contributes to the build-up of leverage and significantly increases volatility in financial markets. When introducing limits on re-use, we find that volatility is strictly decreasing as these limits become tighter, yet the impact on welfare is non-monotone. In the model, allowing for some re-use can improve welfare as it enables agents to share risk more effectively. Allowing reuse beyond intermediate levels, however, can lead to excessive leverage and lower welfare. So the analysis in this paper provides a rationale for limiting, yet not banning, re-use in financial markets.
Keywords: heterogeneous agents, leverage, re-use of collateral, volatility, welfare
JEL Classification: D53, G01, G12, G18
Suggested Citation: Suggested Citation