Collateral

The term "collateral" refers to a tangible asset or a secure financial asset, such as a gov- ernment bond, which is used to guarantee a debt issued by the owner of the asset. The existence of collateral is intended to make the debt less risky, as the creditor has a legal claim on the asset in the case of default by the debtor. As such, collateral is fundamental to the smooth functioning of financial markets.

In this sense, collateral is part of a significant number of lending and borrowing trans- actions undertaken by market participants. For instance, source collateral is provided to investment banks by hedge funds and commercial banks directly, and by other financial market participants such as pension funds and insurers via their custodians (Singh, 2012). While the existence of collateral is crucial to the individual investor, particularly the creditor, collateral also plays an important role in the financial system at the macro- economic level, notably because source collateral is frequently re-pledged, which allows for the creation of collateral chains and hence an interdependent network of lending and borrowing transactions at the aggregate level.

Although this process adds to the so-called lubrication of the financial system, it also introduces an element of fragility, as became evident during the financial crisis of 2008-09.

For instance, the crisis that followed the collapse of the investment bank Lehman Brothers on 15 September 2008 led to a significant shortening of collateral chains as well as a fall in the velocity, or the rate of reuse, of collateral (ibid.), which further aggravated an existing liquidity shortage. In the aftermath of the 2008-09 financial crisis, concerns were also raised that the pool of collateral had shrunk owing to decreasing confidence in many governments' ability to honour their debt commitments. However, such think- ing is flawed in the case of countries like the United States, because a government with monetary sovereignty, and therefore a full capacity to issue its own currency as well as a willingness to honour its debt can never, by definition, be forced into default by any economic circumstance. The case of euroland provides greater room for debate, by con- trast, as all euro-area member countries have relinquished their monetary sovereignty and thus the ability to independently issue their own currency.

Concerns with the role of collateral in propagating business cycles have greater valid- ity and have benefited from significant attention in economic literature. In an economic downturn, as the price of both tangible and financial collateral falls, while simultaneously collateralization and margin requirements increase, potential borrowers find it ever more challenging to secure a loan. This process contributes to a hastier tightening of credit conditions, possibly aggravating and prolonging the economic downturn. However, the literature in this field must be considered with caution, as some models used to study this mechanism, particularly as regards monetary policy, use many assumptions that have been debased by recent developments in economic theory and the US experience during the financial crisis of 2008-09. Assumptions of exogenous money as well as significant changes in inflation rates and thereby in the redistribution of wealth between lenders and borrowers as a result of unanticipated monetary policy shocks (see, for example, Cordoba and Ripoll, 2004) are not only theoretically questionable, but have also been discredited by the monetary policy experience in the aftermath of the 2008-09 financial crisis. Nonetheless, in an economy with endogenous money - that is, where the quantity of money is determined in the process of credit provision - collateral is undoubt- edly fundamental to understanding credit constraints and bank-based financial crises (Ramskogler, 2011).

The evolving role of collateral in many modern economies, such as that of the United States, is thus also crucial to the conduct of monetary policy by the central bank. The efficacy with which the banking system transforms otherwise illiquid assets into liquidity via collateralization in the absence of financial strain means that, when a financial crisis occurs, some of the central bank's traditional tools that aim to provide liquidity to the banking system prove inadequate. In some cases, policies traditionally viewed as expansionary, such as the purchase of government bonds in exchange for reserves at the central bank, prove contractionary, as the policy decreases the stock of valuable collateral (government bonds) that are an essential element in the liquidity creation process of the banking system (Williamson, 2011).

The transformation of the regulatory framework that began following the collapse of Lehman Brothers and the ensuing financial crisis, particularly in the over-the-counter financial products market (Bank for International Settlements, 2013), may lead to a collateral shortage in the long term (van Steenis et al., 2013). Such a collateral short- age, if it occurs, could be a significant drag on economic activity, as it will constrain the loan-creation process that is a fundamental driver of economic growth. On the other hand, over-zealous reuse of collateral, which leads to a masking of underlying risk and the creation of excessive leverage in certain sectors of the economy, was itself one of the fundamental causes of the 2008-09 financial crisis. At the peak of the crisis, the US Federal Reserve took a number of unprecedented steps to ease credit conditions and restore financial stability, with one such step involving a significant expansion of the list of collateral accepted under various loan programmes of the central bank. While this most likely contributed to the reparation of the functioning of financial markets across the world, this measure along with others taken by the US central bank also sparked a debate as to whether the Federal Reserve had overstepped its mandate, entering into the realm of fiscal rather than monetary policy (Wray, 2012).

See also:

Endogenous money; Federal Reserve System; Financial crisis; Investment banking; Open-market operations.