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Collateral, Financial Arrangements and Pareto Optimality

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  • Filippo Taddei

Abstract

The existence of collateral requirements to guarantee repayment on issued securities reduces in general the efficiency of competitive equilibria. The general equilibrium analysis is presented in a world where reputation plays no role, and the lender always expects a future payment equal to the future market value of provided collateral. In this context I show that collateral requirements result in two distinct problems for efficiency. I argue that two financial arrangements, tranching and financial pyramiding, arise in developed capital markets in response to the challenges posed by collateral requirements. If these arrangements are sufficiently developed, then the pareto efficiency of competitive equilibria is restored, even in the presence of collateral requirements.

Suggested Citation

  • Filippo Taddei, 2007. "Collateral, Financial Arrangements and Pareto Optimality," Carlo Alberto Notebooks 64, Collegio Carlo Alberto.
    • Handle: RePEc:cca:wpaper:64
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    References listed on IDEAS

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    1. Atsushi Kajii & Antonio Villanacci & Alessandro Citanna, 1998. "Constrained suboptimality in incomplete markets: a general approach and two applications," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 11(3), pages 495-521.
    2. David Cass & Menahem E. Yaari, 1966. "A Re-examination of the Pure Consumption Loans Model," Journal of Political Economy, University of Chicago Press, vol. 74(4), pages 353-353.
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    4. Geanakoplos, J. & Magill, M. & Quinzii, M. & Dreze, J., 1990. "Generic inefficiency of stock market equilibrium when markets are incomplete," Journal of Mathematical Economics, Elsevier, vol. 19(1-2), pages 113-151.
    5. K. J. Arrow, 1964. "The Role of Securities in the Optimal Allocation of Risk-bearing," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 31(2), pages 91-96.
    6. John Geanakoplos, 2001. "Liquidity, Default and Crashes: Endogenous Contracts in General Equilibrium," Cowles Foundation Discussion Papers 1316R2, Cowles Foundation for Research in Economics, Yale University, revised Jun 2002.
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    Cited by:

    1. Kazuhiro Takino, 2022. "The impact of non-cash collateralization on the over-the-counter derivatives markets," Review of Derivatives Research, Springer, vol. 25(2), pages 137-171, July.

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    More about this item

    Keywords

    Collateral; Pareto Optimality; Financial Arrangements; Tranching; Financial Pyramiding.;
    All these keywords.

    JEL classification:

    • D5 - Microeconomics - - General Equilibrium and Disequilibrium
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

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