Collateral Quality and Intervention Traps

33 Pages Posted: 13 Dec 2017 Last revised: 14 Oct 2022

See all articles by Michael Lee

Michael Lee

Federal Reserve Banks - Federal Reserve Bank of New York

Daniel Neuhann

University of Texas at Austin - Red McCombs School of Business

Date Written: February 28, 2019

Abstract

What determines the supply of good collateral? We study a dynamic model in which borrowers must exert effort to maintain collateral quality and markets become illiquid when average quality is too low. Average quality grows quickly when it is high initially, but deteriorates or grows slowly otherwise. As such, even long-run market conditions are sensitive to a wide array of fundamental and non-fundamental shocks. Recoveries from illiquidity can occur, but only if funding is inefficiently rationed for some time. Policymakers without commitment may fall into intervention traps in which ex-post efficient liquidity injections cause permanent declines in collateral quality.

Keywords: Collateral, Liquidity, Financial Regulation, Financial Intermediation, Adverse Selection, Moral Hazard, Financial Crises

JEL Classification: G01, G21, G28

Suggested Citation

Lee, Michael and Neuhann, Daniel, Collateral Quality and Intervention Traps (February 28, 2019). Available at SSRN: https://ssrn.com/abstract=3087374 or http://dx.doi.org/10.2139/ssrn.3087374

Michael Lee

Federal Reserve Banks - Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States

Daniel Neuhann (Contact Author)

University of Texas at Austin - Red McCombs School of Business ( email )

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