Collateral reuse, collateral mismatch, and financial crises

Abstract

This paper provides a model that links rehypothecation, collateral allocation, and aggregate output. Rehypothecation enhances liquidity provision in normal times as it economizes on scarce collateral, but it can lead to a sharp downturn in crises. The model shows that (i) the size of crisis and the recovery speed can vary across shocks of relatively modest different magnitudes, (ii) poor economic conditions can lead to improved collateral allocation and greater future output via the impact on agents’ decisions on rehypothecation. The model offers a testable prediction of a relation between the volume of rehypothecation, the allocation of collateral, and the aggregate productivity. © 2020 Board of Trustees of the University of Illinois