Contagion in debt and collateral markets

Chang, Jin-Wook and Chuan, Grace (2021): Contagion in debt and collateral markets.

Abstract

This paper investigates contagion in financial networks through both debt and collateral markets. Payment from a collateralized debt contract depends not only on the borrower's balance sheet, but also on the price of the underlying collateral. If the negative liquidity shock is small, then having more connections makes the network safer as contagion through the debt channel is minimized by diversified exposures. Even if the negative liquidity shock is large, collateral can mitigate counterparty exposures and reduce contagion through the debt channel. However, if collateral is not enough (leverage is high) and agents in the network are too interconnected, then collateral price can also plummet to zero and the whole network can collapse. Therefore, we show the importance of the interaction between the level of collateral and interconnectedness across agents. The model also provides the minimum collateral-debt ratio (haircut) to attain a robust macroprudential state for a given network structure and aggregate shock.

• Item Type: MPRA Paper
• Language: English
• Keywords: collateral; financial network; fire sale; systemic risk
• Subjects: D - Microeconomics > D5 - General Equilibrium and Disequilibrium > D52 - Incomplete Markets; D - Microeconomics > D5 - General Equilibrium and Disequilibrium > D53 - Financial Markets; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy; G - Financial Economics > G2 - Financial Institutions and Services > G23 - Non-bank Financial Institutions ; Financial Instruments ; Institutional Investors; G - Financial Economics > G2 - Financial Institutions and Services > G24 - Investment Banking ; Venture Capital ; Brokerage ; Ratings and Ratings Agencies; G - Financial Economics > G2 - Financial Institutions and Services > G28 - Government Policy and Regulation

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