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Resaleable debt and systemic risk

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  • Donaldson, Jason Roderick
  • Micheler, Eva

Abstract

Many debt claims, such as bonds, are resaleable; others, such as repos, are not. There was a fivefold increase in repo borrowing before the 2008–2009 financial crisis. Why? Did banks’ dependence on non-resaleable debt precipitate the crisis? In this paper, we develop a model of bank lending with credit frictions. The key feature of the model is that debt claims are heterogenous in their resaleability. We find that decreasing credit market frictions leads to an increase in borrowing via non-resaleable debt. Such borrowing has a dark side: It causes credit chains to form, because, if a bank makes a loan via non-resaleable debt and needs liquidity, it cannot sell the loan but must borrow via a new contract. These credit chains are a source of systemic risk, as one bank’s default harms not only its creditors but also its creditors’ creditors. Overall, our model suggests that reducing credit market frictions may have an adverse effect on the financial system and even lead to the failures of financial institutions.

Suggested Citation

  • Donaldson, Jason Roderick & Micheler, Eva, 2018. "Resaleable debt and systemic risk," Journal of Financial Economics, Elsevier, vol. 127(3), pages 485-504.
  • Handle: RePEc:eee:jfinec:v:127:y:2018:i:3:p:485-504
    DOI: 10.1016/j.jfineco.2017.12.005
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    References listed on IDEAS

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    More about this item

    Keywords

    Resaleable debt; Systemic risk; Bankruptcy; Repos; Securities law;

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
    • K12 - Law and Economics - - Basic Areas of Law - - - Contract Law
    • K22 - Law and Economics - - Regulation and Business Law - - - Business and Securities Law

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