Collateral Reuse, Collateral Mismatch, and Financial Crises

Abstract

This paper builds a model that links collateral reuse, collateral allocation, and aggregate output. The model shows that collateral reuse affects aggregate output through two channels. First, collateral reuse allows multiple investment projects to be financed by economizing on scarce collateral, thereby increasing aggregate output. Second, collateral reuse may lead collateral to be remained with less efficient hands in case that intermediaries who reused the collateral go bankrupt. These two effects combined with decisions of initial borrowers whether to permit collateral reuse or not affect collateral allocation in the economy, and initiate fluctuations in aggregate output. We show that if a negative shock that increases the default risk of the intermediaries causes the borrower to prohibit collateral reuse, the downturn becomes more severe, while decreased collateral reuse can lead to faster recovery by preventing potential collateral mismatch. We also consider a case with stochastic shocks and show that a long period of boom with high frequency of collateral reuse can be followed by a sharp recession, consistent with observed patterns in the financial crisis.

Keywords: collateral reuse, liquidity, collateral allocation, financial crisis

JEL Classification: D53, D61, E32, G21