Discussion Paper Series 2011-E-25

Collateral Crises

Gary Gorton, Guillermo Ordonez

How can a small shock sometimes cause a large crisis when it does not at other times? Financial fragility builds up over time because it is not optimal to always produce costly information about counterparties. Short-term, collateralized, debt (e.g., demand deposits, money market instruments) -private money- is efficient if agents are willing to lend without producing costly information about the value of the collateral backing the debt. But, when the economy relies on this informationally-insensitive debt, information is not renewed over time, generating a credit boom during which firms with low quality collateral start borrowing. During the credit boom output and consumption go up, but there is increased fragility. A small shock can trigger a large change in the information environment; agents suddenly produce information about all collateral and find that much of the collateral is low quality, leading to a decline in output and consumption. A social planner would produce more information than private agents, but would not always want to eliminate fragility.

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

Copyright © 2011 Bank of Japan All Rights Reserved.

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