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. We find that the role of collateral is mitigating counterparty exposures and reducing contagion but has a phase transition property. Contagion can change dramatically depending on the amount of collateral relative to the debt exposures. When there is enough collateral (leverage is low), then collateral can fully cover debt exposures, and the network structure does not matter. When there is an adequate amount of collateral (leverage is moderate), then collateral can mitigate counterparty contagion, and having more links in the network reduces contagion as interlinkages act as a diversifying mechanism. When collateral is not enough (leverage is high) and agents in the network are too interconnected, then collateral price can 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 state.

• 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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