Contagion in Debt and Collateral Markets

Jin-Wook Chang and Grace Chuan

No 2023-016, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (U.S.)

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 an abundance of 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 the 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-to-debt ratio (haircut) to attain a robust macroprudential state for a given network structure and aggregate state.

Keywords: Collateral; Financial network; Fire sale; Systemic risk (search for similar items in EconPapers)
JEL-codes: D49 D53 G01 G21 G33 (search for similar items in EconPapers)
Pages: 75 p.
Date: 2023-04-11
New Economics Papers: this item is included in nep-ban, nep-fdg, nep-net and nep-ure
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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https://www.federalreserve.gov/econres/feds/files/2023016pap.pdf (application/pdf)

Related works:
Journal Article: Contagion in debt and collateral markets (2024)
Working Paper: Contagion in Debt and Collateral Markets (2021)
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedgfe:2023-16

DOI: 10.17016/FEDS.2023.016

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