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Resaleable debt and systemic risk

Jason Roderick Donaldson and Eva Micheler

Journal of Financial Economics, 2018, vol. 127, issue 3, 485-504

Abstract: Many debt claims, such as bonds, are resaleable; others, such as repos, are not. There was a fivefold increase in repo borrowing before the 2008–2009 financial crisis. Why? Did banks’ dependence on non-resaleable debt precipitate the crisis? In this paper, we develop a model of bank lending with credit frictions. The key feature of the model is that debt claims are heterogenous in their resaleability. We find that decreasing credit market frictions leads to an increase in borrowing via non-resaleable debt. Such borrowing has a dark side: It causes credit chains to form, because, if a bank makes a loan via non-resaleable debt and needs liquidity, it cannot sell the loan but must borrow via a new contract. These credit chains are a source of systemic risk, as one bank’s default harms not only its creditors but also its creditors’ creditors. Overall, our model suggests that reducing credit market frictions may have an adverse effect on the financial system and even lead to the failures of financial institutions.

Keywords: Resaleable debt; Systemic risk; Bankruptcy; Repos; Securities law (search for similar items in EconPapers)
JEL-codes: G21 G28 G33 K12 K22 (search for similar items in EconPapers)
Date: 2018
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