Collateral damage

Article by Mr Claudio Borio, Head of the Monetary and Economic Department of the BIS, Mr Stijn Claessens, Head of Financial Stability Policy and Deputy Head of the Monetary and Economic Department,  Mr Andreas Schrimpf, Head of Financial Markets, and Mr Nikola Tarashev, Head of Financial Systems and Regulation, in VoxEU.org, published on 10 July 2023.

The use of collateral has deepened and broadened financial markets, notably by expanding hedging possibilities. But as this column argues, it comes with side effects that raise financial stability risks of their own. Collateral does protect individual creditors from idiosyncratic defaults in the small – a plus when they are themselves systemic. But by reducing incentives to screen and monitor borrowers, when widely used, it can also increase aggregate leverage and hence the incidence of defaults in the large. And by shifting the loss absorption function to markets, it heightens liquidity risk, which can trigger or amplify system-wide disruptions. Of particular concern today, an adverse shock to the value of government paper used as collateral could trigger destabilising dynamics, including a temporary loss of its safe haven status.