Risky Financial Collateral, Firm Heterogeneity, and the Impact of Eligibility Requirements

50 Pages Posted: 15 Mar 2021 Last revised: 4 May 2022

Date Written: March 12, 2021


How does the eligibility of corporate sector assets as collateral affect collateral supply and risk-taking by the corporate sector? Since banks are willing to pay collateral premia on eligible assets, this makes debt financing cheaper for all firms satisfying eligibility requirements, which are best thought of minimum ratings. We provide a novel analytical characterization of heterogeneous firm responses to collateral easing, i.e., relaxing eligibility requirements. While high-quality firms respond by increasing their debt issuance, some low-quality firms are incentivized to reduce their debt outstanding to benefit from collateral premia. If risk-taking effects are sufficiently large, firm responses increase the resources losses from corporate default. Applying the model to the ECB's collateral easing policy during the 2008 financial crisis, our results suggest that firm responses introduce a central bank trade-off between collateral supply and resource losses of default. Our analysis suggests that a \textit{covenant} conditioning eligibility on debt outstanding \textit{and} current default risk is a powerful instrument to mitigate the adverse impact of collateral premia on default risk while at the same time maintaining a high level of collateral supply.

Keywords: Collateral Premia, Eligibility Requirements, Firm Heterogeneity, Corporate Default Risk, Collateral Policy

JEL Classification: E44, E58, G12, G32

Suggested Citation

Kaldorf, Matthias and Wicknig, Florian, Risky Financial Collateral, Firm Heterogeneity, and the Impact of Eligibility Requirements (March 12, 2021). Available at SSRN: https://ssrn.com/abstract=3800024 or http://dx.doi.org/10.2139/ssrn.3800024

Matthias Kaldorf (Contact Author)

Deutsche Bundesbank ( email )

Florian Wicknig

Deutsche Bundesbank ( email )

Wilhelm-Epstein-Strasse 14
60431 Frankfurt am Main

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