Accounting and Finance Seminar - Kathy Yuan (LSE)

26 February 2020, 1.00 PM - 26 February 2020, 2.15 PM

Kathy Yuan

G.15, 15-19 Tyndalls Park Road

Title - "Safe Assets as Collateral Multipliers"

Abstract - We demonstrate that safe assets, such as reserves and treasury bonds, act as collateral multiplier inanenvironmentwithlimitedcomittmentandadverseselection. Collateralassets, suchasmortgage and bank loans, are often pledged to obtain funding to overcome limited commitment. They are, however, risky and information sensitive, and costly to produce resulting in limited funding capacity. We find safe assets facilitate the production of risky collaterals and increase borrowers’ leverage. Complementaries arise because safe assets lower adverse selection and coordinate investor beliefs in selecting the liquid equilibrium. The optimal design of borrowers’ balance sheet yields liquid debt/illiquid equity tranches as optimal liability. Safe assets and liquid debts are substitutes (in lowering the borrowing cost) and complements (in increasing the size of the balance sheet). When extended to a dynamic setting, safe assets facilitate dynamic coordination and eliminate financial fragility. Our theory has implications on the optimal balance sheet (asset-liability) compositions of banks and their role as liquidity producers, excess cash holdings for corporations, and also for monetary and financial policies.

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