Credit, Collateral and Financial Arrangements

Abstract

The existence of collateral requirements to the exchange of securities in general reduces the efficiency of competitive equilibria. The general equilibrium analysis is presented in a world where reputation plays no role, and the lender always expects a future payment equal to the minimum between the original promise and the future market value of provided collateral.

In this context, I show that collateral requirements result in two distinct problems for efficiency. I argue that two financial arrangements, tranching and financial pyramiding, arise in developed capital markets in response to the challenges posed by collateral requirements. If these arrangements are sufficiently developed, then the pareto efficiency of competitive equilibria is restored.

Keywords: Collateral, pareto optimality, financial arrangements

JEL Classification: D52, D61, G28