Collateralized networks

Samim Ghamami, Paul Glasserman and Hobart Young

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: This paper studies the spread of losses and defaults in financial networks with two interrelated features: collateral requirements and alternative contract termination rules. When collateral is committed to a firm’s counterparties, a solvent firm may default if it lacks sufficient liquid assets to meet its payment obligations. Collateral requirements can thus increase defaults and payment shortfalls. Moreover, one firm may benefit from the failure of another if the failure frees collateral committed by the surviving firm, giving it additional resources to make other payments. Contract termination at default may also improve the ability of other firms to meet their obligations through access to collateral. As a consequence of these features, the timing of payments and collateral liquidation must be carefully specified to establish the existence of payments that clear the network. Using this framework, we show that dedicated collateral may lead to more defaults than pooled collateral; we study the consequences of illiquid collateral for the spread of losses through fire sales; we compare networks with and without selective contract termination; and we analyze the impact of alternative resolution and bankruptcy stay rules that limit the seizure of collateral at default. Under an upper bound on derivatives leverage, full termination reduces payment shortfalls compared with selective termination.

Keywords: contagion; OTC markets; financial regulation; network; fire sales; collateral; automatic stays for qualified financial contracts (search for similar items in EconPapers)
JEL-codes: J50 (search for similar items in EconPapers)
Pages: 24 pages
Date: 2022-03-01
New Economics Papers: this item is included in nep-ban, nep-net and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (6)

Published in Management Science, 1, March, 2022, 68(3), pp. 2202 - 2225. ISSN: 0025-1909

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