Risky Financial Collateral, Firm Heterogeneity, and the Impact of Eligibility Requirements

How does the eligibility of corporate sector assets as collateral affect collateral supply and risk-taking by the corporate sector? Since banks are willing to pay collateral premia on eligible assets, this makes debt financing cheaper for all firms satisfying eligibility requirements, which are best thought of minimum ratings. We provide a novel analytical characterization of heterogeneous firm responses to collateral easing, i.e., relaxing eligibility requirements. While high-quality firms respond by increasing their debt issuance, some low-quality firms are incentivized to reduce their debt outstanding to benefit from collateral premia. If risk-taking effects are sufficiently large, firm responses increase the resources losses from corporate default. Applying the model to the ECB’s collateral easing policy during the 2008 financial crisis, our results suggest that firm responses introduce a central bank trade-off between collateral supply and resource losses of default. Our analysis suggests that a covenant conditioning eligibility on debt outstanding and current default risk is a powerful instrument to mitigate the adverse impact of collateral premia on default risk while at the same time maintaining a high level of collateral supply.