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Resaleable debt and systemic risk

Donaldson, Jason, Roderick and Micheler, Eva (2017) Resaleable debt and systemic risk. Journal of Financial Economics. ISSN 0304-405X

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Identification Number: 10.1016/j.jfineco.2017.12.005

Abstract

Many debt claims, such as bonds, are resaleable, whereas others, such as repos, are not. There was a fivefold increase in repo borrowing before the 2008 crisis. Why? Did banks’ dependence on non-resaleable debt precipitate the crisis? In this paper, we develop a model of bank lending with credit frictions. The key feature of the model is that debt claims are heterogeneous in their resaleability. We find that decreasing credit market frictions leads to an increase in borrowing via non-resaleable debt. Borrowing via non-resaleable debt has a dark side: it causes credit chains to form, since if a bank makes a loan via non-resaleable debt and needs liquidity, it cannot sell the loan but must borrow via a new contract. These credit chains are a source of systemic risk, since one bank’s default harms not only its creditors but also its creditors’ creditors. Overall, our model suggests that reducing credit market frictions may have an adverse effect on the financial system and may even lead to the failures of financial institutions.

Item Type: Article
Official URL: http://www.journals.elsevier.com/journal-of-financ...
Additional Information: © 2017 Elsevier
Divisions: Law
Subjects: H Social Sciences > HB Economic Theory
JEL classification: G - Financial Economics > G2 - Financial Institutions and Services > G21 - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
G - Financial Economics > G2 - Financial Institutions and Services > G28 - Government Policy and Regulation
G - Financial Economics > G3 - Corporate Finance and Governance > G33 - Bankruptcy; Liquidation
K - Law and Economics > K1 - Basic Areas of Law > K12 - Contract Law
K - Law and Economics > K2 - Regulation and Business Law > K22 - Corporation and Securities Law
Sets: Departments > Law
Date Deposited: 18 Oct 2016 11:51
Last Modified: 30 Jan 2019 20:39
Projects: ES/K002309/1
Funders: Economic and Social Research Council
URI: http://eprints.lse.ac.uk/id/eprint/68068

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