The Opportunity Cost of Collateral

Jason Donaldson, Giorgia Piacentino and Jeongmin Lee
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Jason Donaldson: Washington University in St Louis
Giorgia Piacentino: Columbia University
Jeongmin Lee: Washington University in St. Louis

No 1180, 2018 Meeting Papers from Society for Economic Dynamics

Abstract: We present a dynamic model of the repo market in which the liquidity of collateral determines the opportunity cost of lending. Because illiquid collateral is hard to convert to cash to undertake investment opportunities, the opportunity cost of lending against it is high. Hence spreads are high on repos backed by illiquid collateral, even if default risk is not. This opportunity cost channel leads to a new amplification mechanism: a decrease in the liquidity of collateral increases the opportunity cost of capital, contracting credit and depressing asset prices. The option to buy assets at depressed prices spirals back to increase the opportunity cost further, causing a repo run. We solve for the model dynamics following a negative shock to the liquidity of collateral and use the model to assess how much the opportunity cost channel contributed to repo runs in the 2008-2009 crisis.

Date: 2018
New Economics Papers: this item is included in nep-cfn and nep-dge
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed018:1180

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