Discussion Paper Series 2010-E-19

Can Cross-Border Financial Markets Create Endogenously Good Collateral in a Crisis?

Makoto Saito, Shiba Suzuki, Tomoaki Yamada

In this paper, we explore whether markets can create endogenously good collateral in a crisis by analyzing a simple exchange economy where a country-specific catastrophic shock is shared between two countries. To see this possibility, we examine whether the equilibrium achieved by the time-0 complete markets with solvency constraints can be recovered in the dynamically complete markets with collateral constraints. This paper demonstrates that it is possible to recover the time-0 equilibrium outcome in a sequential manner when pricing errors occur randomly in evaluating Lucas trees at a catastrophic event. Such stochastic components may be interpreted as a policy initiative to create good collateral and yield constrained efficient outcomes at crisis periods.

Keywords: Solvency Constraints; Collateral Constraints; Dynamic Optimal Contract; Catastrophic Shocks

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 © 2010 Bank of Japan All Rights Reserved.

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