The Collateral Composition Channel
- American Economic Journal: Macroeconomics (Forthcoming)
Wholesale financial markets reallocate deposits. Because of incentive problems, these flows are limited by endogenous collateral constraints. The composition of collateral matters. The use of inside collateral creates a “collateral pyramid”: cash flows from one loan are pledged to secure another. Outside collateral, such as treasuries, stabilizes the pyramid. Through collateral pyramids the financial sector sustains a large volume of reallocation across banks, but at the cost of systemic panics. During panics, the safe asset creation process stalls, the pyramid collapses, collateral be- comes scarce. Markets are more fragile when loans are secured by inside collateral.
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