Collateralized Debt Networks with Lender Default

Abstract

Re-use of collateral is prevalent in the collateralized debt markets. Lender default naturally arises with re-use of collateral, because a bankrupt lender cannot return collateral to borrowers and inflict costs to them. I develop a model of re-use of collateral with both borrower and lender defaults to analyze systemic risk related to the collateralized debt markets. A debt network keeps track of how agents borrow from each other as well as how the collateral flows through the re-use of collateral. Using a general equilibrium framework, my model endogenizes asset prices, leverage, and debt network simultaneously. The main mechanism of network formation is the borrowers' trade-off between counterparty risk and leverage. Thus, a policy that eliminates the counterparty risk concern, such as mandating central clearing, would make the borrowers only care about maximizing their leverage. This endogenous network response will increase the asset price, leverage, re-use of collateral, and aggregate counterparty exposures. This side-effect is novel because it does not exist if one of asset price, leverage, or network were exogenously given.

Keywords: collateral, re-use of collateral, default, financial networks, systemic risk

JEL Classification: D52, D53, E44, G23, G24, G28