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The impact of systemic and illiquidity risk on financing with risky collateral

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  • Lillo, Fabrizio
  • Pirino, Davide

Abstract

Repurchase agreements (repos) are one of the most important sources of funding liquidity for many financial investors and intermediaries. In a repo, some assets are given by a borrower as collateral in exchange of funding. The capital given to the borrower is the market value of the collateral, reduced by an amount termed as haircut (or margin). The haircut protects the capital lender from loss of value of the collateral contingent on the borrower׳s default. For this reason, the haircut is typically calculated with a simple Value at Risk estimation of the collateral for the purpose of preventing the risk associated to volatility. However, other risk factors should be included in the haircut and a severe undervaluation of them could result in a significant loss of value of the collateral if the borrower defaults. In this paper we present a stylized model of the financial system, which allows us to compute the haircut incorporating the liquidity risk of the collateral and, most important, possible systemic effects. These are mainly due to the similarity of bank portfolios, excessive leverage of financial institutions, and illiquidity of assets. The model is analytically solvable under some simplifying assumptions and robust to the relaxation of these assumptions, as shown through Monte Carlo simulations. We also show which are the most critical model parameters for the determination of haircuts.

Suggested Citation

  • Lillo, Fabrizio & Pirino, Davide, 2015. "The impact of systemic and illiquidity risk on financing with risky collateral," Journal of Economic Dynamics and Control, Elsevier, vol. 50(C), pages 180-202.
  • Handle: RePEc:eee:dyncon:v:50:y:2015:i:c:p:180-202
    DOI: 10.1016/j.jedc.2014.07.004
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Andrea Mazzocchetti & Marco Raberto & Andrea Teglio & Silvano Cincotti, 2018. "Securitization and business cycle: an agent-based perspective," Industrial and Corporate Change, Oxford University Press, vol. 27(6), pages 1091-1121.
    2. Fulvio Corsi & Stefano Marmi & Fabrizio Lillo, 2016. "When Micro Prudence Increases Macro Risk: The Destabilizing Effects of Financial Innovation, Leverage, and Diversification," Operations Research, INFORMS, vol. 64(5), pages 1073-1088, October.
    3. repec:eee:dyncon:v:100:y:2019:i:c:p:200-229 is not listed on IDEAS
    4. Domenico Di Gangi & Fabrizio Lillo & Davide Pirino, 2015. "Assessing systemic risk due to fire sales spillover through maximum entropy network reconstruction," Papers 1509.00607, arXiv.org, revised Jul 2018.

    More about this item

    Keywords

    Systemic risk; Illiquidity; Portfolio overlap; Repo; Haircut; Liquidation;

    JEL classification:

    • G00 - Financial Economics - - General - - - General
    • G01 - Financial Economics - - General - - - Financial Crises
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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