Collateral Shortages and Intermediation Networks

We study a model of financial intermediation in which collateralized, interbank lending is subject to moral hazard, as intermediaries can divert funds towards inefficient projects. We propose a novel propagation mechanism wherein, due to the cumulative nature of moral hazard problems over the network, small changes in collateral liquidity may result in significant drops in the financial system’s intermediation capacity, leading to a complete credit freeze. We show that the financial system’s intermediation capacity crucially depends not only on the quality of assets used as collateral, but also on how such assets are distributed among different intermediaries. Overall, our results show that relying on secured lending contracts, such as repurchase agreements, increases the interconnectedness of the market making it overly fragile.