Collateral or utility penalties?

Wilfredo Maldonado () and Jaime Orrillo ()

International Journal of Economic Theory, 2007, vol. 3, issue 2, 95-111

Abstract: In a two‐period economy with incomplete markets and possibility of default we consider the two classical ways of enforcing the honoring of financial commitments: by using utility penalties and by using collateral requirements that borrowers have to fulfill. First, we prove that any equilibrium in an economy with collateral requirements is also an equilibrium in a non‐collateralized economy where each agent is penalized in their utility if his or her delivery rate is lower than the payment rate of the financial market. Second, we prove the converse: any equilibrium in an economy with utility penalties is also an equilibrium in a collateralized economy. For this to be true, the payoff function and initial endowments of the agents must be modified in a quite natural way. Finally, we prove that the equilibrium in the economy with collateral requirements attains the same welfare as in the new economy with utility penalties.

Date: 2007
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