Dynamic Coordination with Flexible Security Design
54 Pages Posted: 14 Aug 2018 Last revised: 28 Sep 2020
Date Written: September 25, 2020
Borrowers obtain liquidity by issuing securities backed by the dividend and resale price of a long- lived collateral asset. Security design alleviates adverse selection in the securities markets arising from borrowers’ private information about the collateral quality. Security design and asset price are inter-dependent. Higher asset price lowers adverse selection in securities and generates more liquidity via a larger debt tranche and vice versa. When restricted to issuing equity only, dynamic feedback between asset price and collateral quality leads to multiple equilibria. Optimal flexible security design eliminates multiple equilibria, improves welfare through inter-temporal coordination, and can be implemented as term repo.
Keywords: Liquidity; Dynamic Price Feedback; Inter-temporal Coordination; Security Design; Multiple Equilibria; Self-fulfilling Prices; Financial Fragility; Haircut; Repo Runs; Quality-Insensitive Securities; Repo; Asset-Backed Security; Collateral; Limited Commitment; Adverse Selection.
JEL Classification: G10; G01
Suggested Citation: Suggested Citation