ECB working paper: Re-use of collateral: leverage, volatility, and welfare

We assess the quantitative implications of collateral re-use on leverage, volatility, and wel- fare within an infinite-horizon asset-pricing model with heterogeneous agents. In our model, the ability of agents to reuse frees up collateral that can be used to back more transactions. Re-use thus contributes to the buildup of leverage and significantly increases volatility in financial mar- kets. When introducing limits on re-use, we find that volatility is strictly decreasing as these limits become tighter, yet the impact on welfare is non-monotone. In the model, allowing for some re-use can improve welfare as it enables agents to share risk more effectively. Allowing re- use beyond intermediate levels, however, can lead to excessive leverage and lower welfare. So the analysis in this paper provides a rationale for limiting, yet not banning, re-use in financial markets.

The full paper is available at https://www.ecb.europa.eu/pub/pdf/scpwps/ecb.wp2218.en.pdf

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