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The impossibility of effective enforcement mechanisms in collateralized credit markets

Ferreira, Thiago Revil T. and Torres-Martínez, Juan Pablo (2009): The impossibility of effective enforcement mechanisms in collateralized credit markets.

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Abstract

We analyze the possibility of the simultaneous presence of three key features in price-taking credit markets: infinity horizon, collateralized credit operations and effective additional enforcement mechanisms, i.e. those implying payments besides the value of the collateral guarantees.

We show that these additional mechanisms, instead of strengthening, actually weaken the restrictions that collateral places on borrowing. In fact, when collateral requirements are not large enough in relation to the effectiveness of the additional mechanisms, lenders anticipate total payments exceeding the value of the collateral requirements. Thus, by non-arbitrage, they lend more than the value of these guarantees. In turn, in the absence of other market frictions such as borrowing constraints, agents may indefinitely postpone their debts, implying the collapse of the agent's maximization problem and of such credit markets.

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