Costly Collateral and the Public Supply of Liquidity

IMF Working Papers, July 1, 2000

Source details

This paper addresses two complications arising from the use of collateral requirements in debt contracts between wealth-constrained entrepreneurs and banks.
First, costly asset liquidation is found to enhance the susceptibility of debt finance to interest rate volatility.
Second, aggregate uncertainty in conjunction with limited bank capitalization is shown to produce excessive credit constraints that, under certain conditions, justify the public supply of liquidity.
The paper suggests applications with respect to models of interest rate smoothing and self-fulfilling currency crises.

Costly asset liquidation increases vulnerability of debt finance to interest rate volatility.
Aggregate uncertainty combined with limited bank capitalization can produce excessive credit constraints.
Under certain conditions, these excessive credit constraints justify the public supply of liquidity.
Suggested applications include:
- Models of interest rate smoothing.
- Models of self-fulfilling currency crises.

Subject: Asset prices, Banking, Collateral, Credit, Financial institutions, Labor, Loans, Money, Prices, Self-employment
Keywords: asset collateralization, asset liquidation, asset price uncertainty, Asset Price Volatility, Asset prices, bank profit variability, bank solvency consideration, bank solvency constraint, Collateral, contingent contract, Credit, Credit Constraints, Debt Finance, external finance, interest rate, Loans, net loan rate, optimal contract, rate repayment, representative bank, Self-employment, solvency constraint, WP

Costly Collateral and the Public Supply of Liquidity - WP/00/125
- Costly Collateral and the Public Supply of Liquidity - WP/00/125 (Markdown version)
- Costly Collateral and the Public Supply of Liquidity - WP/00/125 (PDF)