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Collateralized Networks

Author

Listed:
  • Samim Ghamami

    (University of California, Berkeley, Berkeley, California 94720; New York University, New York, New York 10012; Financial Services Forum, Washington, District of Columbia 20005)

  • Paul Glasserman

    (Columbia Business School, New York, New York 10027)

  • H. Peyton Young

    (London School of Economics, London WC2A 2AE, United Kingdom; University of Oxford, Oxford OX1 2JD, United Kingdom)

Abstract

This paper studies the spread of losses and defaults in financial networks with two interrelated features: collateral requirements and alternative contract termination rules. When collateral is committed to a firm’s counterparties, a solvent firm may default if it lacks sufficient liquid assets to meet its payment obligations. Collateral requirements can, thus, increase defaults and payment shortfalls. Moreover, one firm may benefit from the failure of another if the failure frees collateral committed by the surviving firm, giving it additional resources to make other payments. Contract termination at default may also improve the ability of other firms to meet their obligations through access to collateral. As a consequence of these features, the timing of payments and collateral liquidation must be carefully specified to establish the existence of payments that clear the network. Using this framework, we show that dedicated collateral may lead to more defaults than pooled collateral, we study the consequences of illiquid collateral for the spread of losses through fire sales, we compare networks with and without selective contract termination, and we analyze the impact of alternative resolution and bankruptcy stay rules that limit the seizure of collateral at default. Under an upper bound on derivatives leverage, full termination reduces payment shortfalls compared with selective termination.

Suggested Citation

  • Samim Ghamami & Paul Glasserman & H. Peyton Young, 2022. "Collateralized Networks," Management Science, INFORMS, vol. 68(3), pages 2202-2225, March.
    • Handle: RePEc:inm:ormnsc:v:68:y:2022:i:3:p:2202-2225
    DOI: 10.1287/mnsc.2020.3938
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    References listed on IDEAS

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    3. Zachary Feinstein & Andreas Sojmark, 2022. "Endogenous distress contagion in a dynamic interbank model: how possible future losses may spell doom today," Papers 2211.15431, arXiv.org, revised Aug 2024.
    4. Zhiyu Cao & Zachary Feinstein, 2023. "Price-mediated contagion with endogenous market liquidity," Papers 2311.05977, arXiv.org, revised Sep 2024.

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