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Chained financial frictions and credit cycles

Federico Lubello, Ivan Petrella () and Emiliano Santoro ()

No 116, BCL working papers from Central Bank of Luxembourg

Abstract: We examine the role of bank collateral in shaping credit cycles. To this end, we develop a tractable model where bankers intermediate funds between savers and borrowers. If bankers default, savers acquire the right to liquidate bankers' assets. However, due to the vertically integrated structure of our credit economy, savers anticipate that liquidating nancial assets (i.e., bank loans) is conditional on borrowers being solvent on their debt obligations. This friction limits the collateralization of bankers' financial assets beyond that of other assets that are not involved in more than one layer of financial contracting. In this context, increasing the pledgeability of financial assets eases more credit and reduces the spread between the loan and the deposit rate, thus attenuating capital misallocation as it typically emerges in credit economies a la Kiyotaki and Moore (1997). We uncover a close connection between the collateralization of bank loans, macroeconomic amplification of shocks and the degree of procyclicality of bank leverage. A regulator may reduce macroeconomic volatility through the introduction of a countercyclical capital buffer, while a fixed capital adequacy requirement displays limited stabilization power.

Keywords: Banking; Bank Collateral; Liquidity; Capital Misallocation; Macroprudential Policy. (search for similar items in EconPapers)
JEL-codes: E32 E44 G21 G28 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ban, nep-dge, nep-fdg and nep-mac
Date: 2018-02
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