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Collateral quality and intervention traps

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  • Lee, Michael Junho
  • Neuhann, Daniel

Abstract

What determines the supply of good collateral? We study a dynamic model in which borrowers must exert effort to maintain collateral quality and markets become illiquid when average quality is too low. Average quality grows quickly when it is high initially, but deteriorates or grows slowly otherwise. As such, even long-run market conditions are sensitive to a wide array of fundamental and non-fundamental shocks. Recoveries from illiquidity can occur, but only if funding is inefficiently rationed for some time. Policymakers without commitment may fall into intervention traps in which ex-post efficient liquidity injections cause permanent declines in collateral quality.

Suggested Citation

  • Lee, Michael Junho & Neuhann, Daniel, 2023. "Collateral quality and intervention traps," Journal of Financial Economics, Elsevier, vol. 147(1), pages 159-171.
    • Handle: RePEc:eee:jfinec:v:147:y:2023:i:1:p:159-171
    DOI: 10.1016/j.jfineco.2022.10.005
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    References listed on IDEAS

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    More about this item

    Keywords

    Collateral; Liquidity; Adverse selection; Credit market interventions; Financial fragility;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G20 - Financial Economics - - Financial Institutions and Services - - - General

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