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Collateral Re-use, Liquidity and Financial Stability

Matteo Accornero ()
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Matteo Accornero: Department of Social Sciences and Economics, Sapienza University of Rome

No 10/20, Working Papers from Sapienza University of Rome, DISS

Abstract: This work provides a model where the repercussions on financial stability of collateral re-use in repo contracts can be analysed and assessed. In the model, the rationale for repo contracts is the arbitrage activity of a leveraged hedge fund, which is profitably financed by a dealer bank. Repo contracts, in connection with collateral re-use, lubricate both the credit and the financial system, increasing the financial operators’ profits and improving equilibrium rates and volumes. At the same time, they amplify the leverage of the whole economy, making it vulnerable to shocks. Introducing a default risk for the hedge fund, the proposed model identifies diverging effects of collateral re-use on financial stability. In states with low dealer bank profitability, the increase in collateral re-use renders a sound dealer bank management style the profit maximising strategy. Where an unsound balance sheet expansion is highly profitable, the increase in collateral re-use provides destabilising incentives to the dealer bank.

Keywords: repo markets; collateral re-use; rehypothecation; systemic risk (search for similar items in EconPapers)
JEL-codes: E58 G01 G21 G23 (search for similar items in EconPapers)
Date: 2020-05
New Economics Papers: this item is included in nep-cfn, nep-mac and nep-rmg
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