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ORIGINATE-TO-DISTRIBUTE BANKING MODEL
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T i t o l o : RI SK- TAKI NG AND ASSET- SI DE CONTAGI ON I N AN ORI GI NATE- TO- DI STRI BUTE BANKI NG
I SBN: 978 88 84 67 611 5
Pr i ma Edi zi one: Agost o 2010
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w w w . c u e c . i t
Risk-Taking and Asset-Side Contagion in an
Originate-to-Distribute Banking Model
Queen Mary, University of London
During the Subprime crisis the entire banking industry risked
collapsing under an unprecedented lack of liquidity. This work
tries and ﬁnd what channel allowed a relatively small systemic
shock, the increased mortgage delinquency in the US housing
market, to spread worldwide with such a terriﬁc impact.
I develop a model of ﬁnancial contagion where banks adopt-
ing the originate-to-distribute model satisfy their liquidity needs
through repurchase agreements in the money market.
I assume there are no early diers in the economy, and I look at
crises originating from inaccurate forecasting of asset returns by
some banks. The crisis may be inefﬁcient since accurate banks
with good fundamentals are unable to roll over their debt and
go bankrupt. There is room for the regulator to make accurate
banks willing to rescue failing banks.
JEL Classiﬁcation: G01, G24, G32, G33.
Keywords: Repos, Haircut, Rollover, Financial Crises.
I thank Giovanni Cespa, Luca Deidda, Xavier Freixas, Winfried Koeniger,
and seminar partecipants at the Universitat Pompeu Fabra, University of
Cagliari and Queen Mary, University of London for useful comments.
By raising liquid assets, gathering information and spreading risks, ﬁ-
nancial markets should allow the real economy to achieve an efﬁcient
allocation of ﬁnancial resources toward investment.
However, the Subprime crisis suggests that the functions performed
by ﬁnancial markets might be hampered because of the possibility of
The present paper proposes a new way to model the crisis of 2007-
2009: primarily, pointing at asset mispricing as the source of the tur-
moil. The aim of this approach is to capture the role “opaque” deriva-
tives play in determining the possibility of a crisis.
Secondly, I analyse the process of contagion through the market for
liquidity, stressing the role strategic interdependencies play in spread-
ing the ﬁnancial trouble from one investment bank to the whole sys-
I ﬁnd that the misevaluation of risky return by some banks can lead
bankrupt otherwise solvent competitors, so as to determine an inefﬁ-
cient ﬁnancial crisis.
If the realization of the return is much lower than expected by incon-
siderate banks, the latter go bankrupt and some lenders in the money
market suffer capital losses.
This decreases the amount of liquidity that is available to lend against
pledgeable assets for the following period.
Pledgeable assets can therefore be undervalued on the basis of cash-in-
the-market pricing, like in Allen and Gale (1994). Any decrease in the
price of collateral affects its pledgeable value, and lowers banks ability
to fund their liquidity needs.
The insolvency of some inconsiderate banks may thus make consid-
erate banks illiquid.
“The sell-side of the market (dealer banks, CDO and SIV managers) understands
the complexity of the subprime chain, while the buy-side (institutional investors) does
The amount of liquidity in the market for collateralized debt decreases only if
potential investors have not enough time to enter the market between the discovering
of the risky return and the rollover date. However, according to Brunnermeier (2009),
"Almost 25 percent of [investment banks’] total assets were ﬁnanced by overnight
repos in 2007".
This interdependence among institutions plays a role in the cost a
government has to bear to stop the contagion.
In fact, if the government commits to inject an amount of liquidity
not exceeding the industry net shortage, the risk of contagion inﬂu-
ences the scope for vulture-like strategies and liquidity hoarding.
Since Diamond and Dybvig (1983) and Bryant (1980) seminal works
on bank runs, researchers have insisted on the fragility brought about
by the banking activity.
Allen and Gale (1988), Goldstein and Pauzner (2005), and Jacklin and
Bhattacharya (1988) enriched the analysis linking depositors’ expecta-
tions to the business-cycle.
Adrian and Shin (2009), Allen and Gale (2000), Brusco and Cas-
tiglionesi (2007), Freixas, Parigi and Rochet (2000), Rochet and Vives
(2004), although keeping much of their framework in the same vein as
previous works on bank runs, tried and single out the channels through
which the run on one bank may trigger a systemic ﬁnancial crisis.
These models pointed out that a domino effect is able to spread the
trouble of one bank, originated by endogenous panics or new informa-
tion, to other ﬁnancial institutions through cross-defaults.
Domino models account for the importance of banks providing each
other mutual insurance through the interbank market for liquidity.
Nevertheless, they paint a picture of passive ﬁnancial institutions,
that stand by and do nothing as the sequence of defaults unfolds.
The domino approach does not consider the effect market forces and
mark-to-market accounting have on the reliability of banks.
The impact of price changes on the book value of banks asset is in
fact likely to increase the negative effect of counterparties’ defaults.
Allen and Gale (2004), Diamond and Rajan (2005), and Cifuentes,
Shin and Ferrucci (2005) show that the interaction among changes in
asset prices and solvency requirements amplify any initial shock.
The reduction in the value of a marked-to-market balance sheet may
force a bank to respond selling its risky assets, whose value is weighted
by their risk measure, with cash. That should increase prima facie the
bank’s value for regulatory purposes.
However, if the asset demand is not perfectly elastic, sales induce a
further decline in its marked-to-market portfolio of assets that might
outweigh the effect of the initial response.
In these models contagion, far frombeing caused by interbank claims,
results from the fall in the value of banks portfolios.
To take this approach, one needs to single out a proper source of
rigidity in asset pricing in the ﬁnancial market.
Shleifer and Vishny (1992) analyse the equilibrium aspect of asset
sales in a generic industry and describe the coming up of ﬁre sales,
namely sales at trading price lower than the fair price of the asset, when
ﬁnancial distress hits companies with specialized assets. When a ﬁrm
must sell assets because of ﬁnancial distress, the potential buyers with
the highest valuation for the specialized asset are other ﬁrms in the
same industry, who are likely to be in a similarly dire ﬁnancial situa-
tion and may therefore be unable to supply liquidity.
One can imagine that the same story ﬁts the ﬁnancial market: be-
cause of asymmetric information or specialised investments strategies,
outsiders are willing to pay the asset less than its industry-speciﬁc value.
The asset price then decreases, the depreciation being higher for as-
sets that are highly specialized or difﬁcult to evaluate.
Adrian and Shin (2009) provide evidence in support of such a re-
sult, showing that marked-to-market leverage is strongly procyclical.
The authors show that institutional investors respond to changes in
the value of their portfolio moving their leverage in the same direction
as the market does.
Thus market participants sell when prices slump, in a manner that
reinforces the price trend.
Because the liquidity available within the industry in the short run
is given by the banks’ portfolio decisions at the initial date, substantial
sales can lead to a drop in prices.
As the asset price falls, the bank has to sell an even larger proportion
of its long-termassets in order to abide by solvency constraints imposed
by the regulator.
The asset price can slump so dramatically that the bank cannot meet
its commitments even if it liquidates all its long-term assets. At the
same time, other banks ﬁnd the value of their assets not sufﬁcient to
fulﬁll their commitments and start selling, so putting the trading price
under even higher pressure.
In force of the central bank readiness, the present work focuses on
the role played by linkages among banks, namely a market to borrow
liquidity against collateral, when depositors do not care about a drop
in banks’ portfolio.
There are no early diers in the economy, and depositors do not run
their banks because the limited convertibility keeps deposits safe.
This allows to focus on the effect the misevaluation of opaque securi-
ties has on banks ability to borrow, rather than on the exogenous need
for liquidity of a portion of depositors.
The paper is organised as follows. In section 2 I give an informal
account of the Subprime crisis. In section 3 I present the model and
characterize the banks optimal portfolio allocation. In section 4 I de-
scribe the impact of interim information on the banking sector. In
section 5 I show how the misevaluation made by some banks propa-
gates as a liquidity crisis. Section 6 deals with the policy implications
of the newly found contagion channel. In section 7 I present a numeric
example. Section 8 concludes.
2 Modeling the Subprime Crisis
Most extant explanations of ﬁnancial crises emphasise the negative ex-
ternalities on the liabilities side of the balance sheet: it is the run by
depositors that precipitates a crisis.
By virtue of the policies suggested in these works, central banks man-
aged to relegate demand-driven bank crises to break out in text books
more often than in newspapers.
Nevertheless, such a phenomenon came back in 2007 in the UK, one
century after the most recent bank run in the British banking system,
when many depositors queued to withdraw their deposits in Northern
The Subprime crisis, able to set off such secular event, questioned
our understanding of ﬁnancial crises.
In fact, the ﬁnancial crisis of 2007-2009 does not ﬁt either the account
given by models on self-fulﬁlling prophecies or those stemming from
shock on fundamentals.
This criticism constitutes the primary motivation to the present pa-
per and stems from a key stylized fact: depositors do not seem to have
played a primary role in the crisis.
To begin with, banks experienced difﬁculties before anything hap-
pened to liquidity demand, and kept secret this bad news as long as
Only after investors faced troubling information on the solvency of
the banking industry in the near future, they withdrawn their endan-
Furthermore, central banks and governments have succeeded in build-
ing up credibility as institutions ready to do anything for the sake of
retail depositors and ﬁnancial stability.
Thus a consumer panic, either driven by prophecies, interim signals
or asymmetric information, does not give a satisfactory motivation for
this crisis to materialize.
Whilst all the models mentioned thus far relied on preference shocks
to justify the emergence of a run, Cifuentes, Ferrucci and Shin (2005)
refrain from characterising what kind of blow hits the economy.
The authors focus on the way solvency constraints create liquidity
risk in a systemof interconnected ﬁnancial institutions, when the latter
mark their assets to market. They assume that a given shock on the
asset side lets a bank violate a solvency constraint, namely a liquidity
ratio. The hit bank must sell part of its assets to avoid contravening the
The demand for the asset being less than perfectly elastic, sales by the
distressed institution lower their market value. Thus, assets are marked
at a new lower trading price and the solvency constraints may dictate
further disposals, leading the whole banking sector to collapse.
2.1 Literature on the crisis of 2007-2009
The paper by Cifuentes, Ferrucci and Shin (2005) belongs to a tiny
strand of literature that does not rely on early diers to account for the
precipitation of a crisis.
Although the interest on modelling ﬁnancial crises has gained mo-
mentum since the occurrence of the Subprime crisis, the vast majority
Shin (2008) reports on the run to Northern Rock: “The Bank of England was in-
formed [of Northern Rock’s funding problems] on August 14th. From that time until
the fateful announcement on September 14th that triggered the deposit run (i.e. for a
full month), the Financial Service Authority and Bank of England sought to resolve
the crisis behind the scenes, possibly arranging a takeover by another UK bank.”
of papers on the subject still focuses on preference shocks.
This is certainly convenient, in that early diers naturally create scope
for an interbank market the crisis can spread through. However, as
mentioned at the beginning of this section, preference shocks do not
seems to have played a role in the materialisation of the last crisis.
Heider, Hoerova and Holthausen (2009) model an interbank market
where ﬁnancial institutions lend money to each other in order to deal
with the traditional issue of early diers.
The authors introduce asymmetric information about counterparty
risk among banks. The private information each bank has on its risky
investment produces adverse selection and can lead the unsecured in-
terbank market to freeze.
Diamond and Rajan (2010) show that the overhang of illiquid assets
increases the future return of holding them in the eve of ﬁre selling.
Opaque ABSs are likely to depreciate much, in that they can be valued
only by some specialized ﬁrms.
Thus, the prospect of buying undervalued assets in the near future
induces endangered banks to hold them with the hope that they will
appreciate before it is too late.
In a parallel work to this paper, Acharya, Gale and Yorulmazer (2010)
emphasise the role played by rollover and liquidation risk in the Sub-
prime crisis. Similarly to the present paper, they allowbanks to borrow
liquidity through repo agreements in the money market.
In a two-state model, the authors show that in the bad scenario the
pledgeable value of an asset is lower than its fundamental value. The
reason is that, when the frequency of rollover is very high, it is very
unlikely that there will be good news able to make the value of the
asset jump to the good state by the rollover date.
They assume banks assets have a liquidation cost. Thus, in order to
avoid the cost of bankruptcy, borrowing banks do not issue debt with
face value higher than their low-state debt capacity.
Even a small decrease in the fundamental value of the asset at a rollover
date may thus cause a large fall in the bank debt capacity. The effect can
be so important that the market for secured borrowing freezes.
To the best of my knowledge, the model by Acharya, Gale and Yorul-
mazer (2010) is the only one on the Subprime crisis that does not focus
neither on the infringement of regulatory provisions due to early diers
nor on exogenous changes in haircut.
On the one hand, regulators were most likely willing to loosen their
provisions to stop the crisis. On the other hand, the change in hair-
cuts was undoubtedly an important channel for contagion, for lenders
updated their expectation of the counterparty risk.
The contagion channel pointed out in this paper adds to the effect of
a haircut increase.
The surge of counterparty risk stemming from the discovery of as-
set misevaluation from some banks, and the consequent widening of
lending margins, is neglected in the paper but would deepen the crisis.
Nevertheless, haircuts are kept steady at their initial value to disen-
tangle the primary role asset misevaluation and market risk played in
the occurrence of the crisis of 2007-2009.
One novelty of the Subprime crisis was in fact the reliance of the
banking industry on short-term ﬁnancing against highly opaque secu-
rities that were difﬁcult to price.
2.2 The ﬁctitious separation between banks and SPVs
The Subprime crisis did not unfold in the traditional commercial bank-
ing sector considered in most former works on ﬁnancial turmoils.
The reason why the model developed in this paper alludes to depos-
itors is to stress its contribution to the previous literature and make
consistent the comparison of its results with models of contagion based
on bank runs.
To account for the crisis of 2007, the reader shall interpret deposi-
tors as investors in an investment bank, whilst the bank that collects
depositors’ liquidity can be recast as a complex economic entity made
by an investment bank and a Special Purpose Vehicles (SPV), as many
ﬁnancial institutions set up in the years preceding the crisis of 2007.
The rationale for this uniﬁed treatment is explained below.
Special vehicles are off-balance legal entities that investment bank
created in order to attain high levels of leverage without breaching
banking regulatory provisions.
Banks are in fact allowed to invest only a limited portion of their
capital in risky assets - e.g. loans to noninstitutional borrowers.
For regulatory purposes, the size of the risky investment is its value
in the bank trading book, weighted by a measure of its risk.
By transferring the risky investment to a SPV a bank could enjoy the
return on the loans it issued, without making the liability appear on
the trading book and incur regulator’s intervention.
The SPV played also a second role on behalf of the parent bank. It
could issue Asset Backed Securities (ABSs) representing claims on the
cash ﬂow paid by the pool of risky assets it received by the bank.
The SPV could either trade the securities or use them as collateral, to
borrow liquidity from investors through repurchase agreements in the
Securitization played a particularly important role in the subprime
market, until the crisis hit. Gorton and Metrick (2010) point out that in
2005 and 2006 Subprime mortgage origination was about $1.2 trillion
of which 80% was securitized in different seniorities.
As a consequence of the seemingly interminable appreciation in house
prices, the cash ﬂow to the securities was assured by the opportunity
to make the borrower reﬁnance the property before defaulting on his
mortgage, just a couple of years after it was originated, or to repossess
the inﬂated property and recoup the whole credit.
Adopting such a strategy, the SPV gathered cash the parent bank
could use to both increase its position in the risky asset and smooth
its available liquidity before the risky asset pays out its return.
Nevertheless, the SPV having a portfolio solely made of risky assets,
it could not borrow liquidity under favourable terms without proper
Hence, parent banks ensured they would provide backstop liquidity
if the cash ﬂows delivered by the pool of loans appeared insufﬁcient to
fulﬁll the claims by investors who accepted the ABSs as collateral.
A bank could thus originate risky loans and create a SPV, to have
risky assets bought out of the bank balance sheet. The SPV ﬁnanced
the acquisition by issuing securities backed by the same loans, with
the opportunity to pay low interests on its debt in force of the two
key elements of the originate-to-distribute model: the liquidity con-
duit granted by the originating bank, and the endorsement received by
Reputational credit lines needed no capital charge under the banking regulation.
In fact, ABSs issued by SPVs were not simple claims on the pool of
loans. Vehicles cooperated with rating agencies to package the loans
in opaque structured securities, characterized by a credit report rather
than by information on the asset backing them.
At the beginning of 2007, the delinquency rate of US subprime non-
institutional borrowers revealed higher than expected by most investors
in securities backed by those loans. Thus, the credit ratings assigned by
agencies to most ABSs proved to be wrong.
Parent banks had to activate the liquidity backstops to their SPVs
and, at the same time, the market value of ABSs held by the vehicles
fell to adjust to the new expected return.
As soon as SPVs in Europe and the US started experiencing difﬁcul-
ties, it became clear that the separation between those entities and their
parent banks was ﬁctitious.
The originate-to-distribute model was a convenient way to overcome
regulation on leverage and increase banks’ revenues, when the risky
assets were yielding a positive return.
However, when the event regulatory provisions on leverage were
meant to protect from took place, failing SPVs and their parent banks
shown to be the same economic entity.
The portfolios of ABSs having a lower market value, the single entity
bank-SPV, hit by the negative shock, faced a fall in its ability to borrow.
It could then end up short of the liquidity needed to fulﬁll the com-
mitment with its investors, as well as with the regulator.
For this reason I model the originate-to-distribute lending activity at
the root of the crisis as if the investment bank and its SPV were the
same economic entity. This rules out the ﬁctitious separation actual
banks adopted merely for regulatory arbitrage purposes.
2.3 Liquidity funding in the banking industry
The effect ABSs depreciation had on the bank-SPV ability to borrow
was exacerbated by the nature of its ﬁnancing contracts.
"In the second half of 2007, Moody’s downgraded more bonds that it had over the
previous 19 years combined". The Financial Times, 18 October 2008.
The main source of liquidity to SPVs consisted in short term- mostly
overnight - Repurchase Agreements (repos) with investors in the money
If the borrower can not repay his debt, the lender in a repo agreement
becomes owner of the collateral and sells it in the ABS market, using
the proceeds as repayment of its claims.
Rather than securing the funding before investing in risky loans, the
entity could get the liquidity it needed to originate them - or to buy
them in the secondary market - by pledging securities backed by those
Banks had the opportunity to originate a loan, securitize the claims
and pledge them as collateral in a repo agreement, secure the funds
needed for the loan to be issued and, ﬁnally, use the borrowed liquidity
to issue an amount of loans far above the internal capital they invested
in the risky lending activity.
The difference between interests earned on the risky loan and the
repo interest paid to lenders was thus a net gain. The bank could realize
it because of the leverage secured by its SPV on the repo market.
Hence, the value of investing one unit of capital in a risky asset,
namely the lending activity, was worth to the bank-SPV more than
its face value.
A bank-SPV beneﬁted from the usage value of the securities backed
by its pool of loans. This amounts to the additional liquidity, borrowed
against ABSs issued by the SPV, the bank can invest in further remu-
Such a money multiplier would allow the bank to leverage indeﬁ-
nitely, if it was not for the additional guarantee money market investors
ask as the liquidity cushion of the entity bank-SPV becomes less signif-
In repo agreements, lenders protect themselves against possible fall
in the collateral market value applying a margin between the price of
collateral at the start date of the contract and the amount of liquidity
the counterparty can borrow against the pledged asset.
In this paper the choice made by investors about this haircut is en-
dogenous to the model. I assume lenders measure their exposure to the
borrower in terms of Value at Risk (VaR).
The VaR of an investment is the upper bound potential losses do not
exceed with some predetermined probability, called a conﬁdence inter-
val, according to the probability distribution of the asset liquidation
2.4 Outline of the model
The subprime crisis began with the discovery that highly structured
ﬁnancial derivatives were overpriced.
Starting from such stylized fact,
this paper relies on wrong evaluation of opaque asset returns to propose
a new contagion channel in ﬁnancial markets.
Secured borrowing with high rollover frequency is shown to make
the amount of liquidity banks can raise against their illiquid collateral
strongly depend on other banks’ misevaluation.
Banks discovering highly overpriced securities in their portfolios lack
pledgeable value and ﬁnd it impossible to borrow the liquidity they
committed to pay their investors.
At the ﬁrst date, banks make their investment decision and com-
mit to periodical payments they must deliver in the future to avoid
Each institution sets the level of settlements equal to the amount of
liquidity it expects to hold at each date, according to its estimate of the
return on risky assets and its pledgeability.
If one introduces a market for liquidity, where banks can raise some
cash at the interim date against the value of their illiquid asset, the
wrong assessment made by a bank can set off a contagion.
The value of pledgeable assets depends on their market value. Thus,
the prevailing trading price of illiquid assets determines, at each date,
the amount of cash every bank can collect against the risky assets it
chose to invest in at the initial date.
If a bank hit by an interim shock goes bankrupt, its investment in
the risky asset is liquidated by lenders to recoup the face value of debt.
The new fundamental value of collateral can be too low for some
lenders to avoid breaching their VaR limits. This, in a market with lim-
ited participation, determines cash-in-the-market pricing and an asset
The paternity of this mistake is not addressed here, although the moral hazard
problem with rating agencies and the lack of time series on new custom-made products
seem very good explanations.
price below its fundamental value.
In the present model, such an outcome is highly likely to take place.
In fact, the same opaqueness that contributes to the misevaluation of
the risky asset makes the intervention by outsider investors costly.
The result is that the amount of cash all fundamentally solvent banks
can rise against their positions in the same illiquid investment falls.
The bankruptcy of one bank may then put in trouble some banks
non-hit from the initial shock. Other investors breach their VaR limit
and the asset price falls even further, possibly endangering even banks
that were hit positively by the initial shock.
A public injection of liquidity is very costly in this framework, and
it may turn out to be inefﬁcient for the usual moral hazard concerns.
It is then worthwhile to assess whether the regulator can set up a self
enforcing coordinating mechanism in the interbank liquidity market.
The result of the model is reassuring in this respect. Differently from
what found by Diamond and Rajan (2009) and Acharya, Gromb and
Yorulmazer (2008), banks unaffected by the interim shock have no in-
centive to hoard liquidity or to adopt a vulture-like strategy.
They prefer to take second best decisions on the purchase of illiquid
assets previously owned by inconsiderate banks to bail out themselves.
The threat of contagion is part of this mechanism. It can save the
government the cost of injecting liquidity in the attempt to prevent
the ﬁnancial sector from freezing the functions it performs for the real
In fact, when a crisis spreads through the channel pointed out in this
paper, the only way a government has to stop the contagion is by buy-
ing pledgeable assets to sustain their price. Public intervention has to
keep the price inﬂated, in order to maintain the pledgeable value of
banks portfolio to a sustainable level until the illiquid investment pays
its return to solvent but otherwise illiquid banks.
"In a survey of 120 banks in 24 developed countries in the 1980’s and 1990’s,
Goodhart (1995) found that two out of three failed banks were bailed out (...) Patrick
Honohan and Klingebiel (2000) found that, on average, countries spend 12.8 percent
of their GDP cleaning up their banking systems." Gorton and Huang (2004).
This analysis is performed in a framework with n = 2 banks in the present paper,
whilst the issue of coordination when n > 2 is being assessed in a parallel work in
progress "Liquidity Shortages and the Viability of a Superfund".
The purpose of the present work is to formalise the above mentioned
channel for contagion and banks incentive to bailout the industry.
3 The model
Consider a multi-region economy lasting for three dates t = 0, 1, 2.
There is no discounting and the risk free rate is normalised to zero.
The economy is populated by depositors, banks, funds, and nonin-
stitutional borrowers. Projects undertaken by the latter type of players
are the only source of return in the model.
Each region i = 1, ..., n is endowed at the initial date with one unit of
liquidity, proportionally owned by a continuum of depositors.
Among depositors there are no early diers, to use the jargon of previous
literature. Their preferences are homogeneous and described by the
) = min(c
is the amount of liquidity a depositor can use to afford con-
sumption at date t .
Thus, there are no shocks in the demand for liquidity, and depositors
prefer to smooth their consumption over periods.
Depositors from each region have the opportunity to put their en-
dowment in the regional banking industry, in order to access its in-
vesting technology and afford at each future date t = 1, 2 the highest
possible amount of consumption good.
Since there are no early diers, depositors do not run their banks on
the basis of coordination problems. Furthermore, since they strictly
prefer smooth consumption over time, a contract that speciﬁes c
is optimal. Such a contract is akin to limited convertibility and there-
fore depositors never run their bank.
b) Noninstitutional borrowers
Noninstitutional borrowers face a long-term entrepreneurial project
and get from banks the external capital needed to undertake it.
ferently from depositors, these agents can deal with banks from any
They borrow the money needed at the initial date, and their ability
to repay the loan at the ﬁnal date depends on the project outcome.
Borrowers have limited liability but are homogeneous and need ex-
ert no effort to affect a project probability of success, nor can they
misrepresent the project return.
Thus there are no agency problems between banks and borrowers.
The latter are just a black box banks can access remunerative projects
Regional banking industries are perfectly competitive. Banks receive
from each depositor a fee ∆ for managing her liquidity.
In order to outperform its competitors, every bank has to offer de-
posit contracts maximising depositors’ utility in its region. Thus, banks
maximize the amount of liquidity they commit to give depositors at
As mentioned above, banks can lend part of depositors’ liquidity
to noninstitutional borrowers. Each bank takes its lending decision
upon the loans repayment it expects at the ﬁnal date, having observed
a region-speciﬁc signal on the realization of exogenous factors that af-
fect the project return.
Banks optimization problem amounts to select what share of de-
posits to invest in lending to noninstitutional borrowers and what to
be held as cash, together with a commitment on the periodic payment
paid to depositors at dates t = 1, 2.
Banks choose their portfolio allocation and commitment with de-
positors under a solvency constraint. A bank goes bankrupt if, at any
Borrowers can be consumers who want to buy a home, to account for the category
of borrowers the 2007-2009 crisis generated from, as well as other agents involved in
date, its available liquidity is lower than the amount it had committed
The capital banks in each region can use to ﬁnance entrepreneurial
projects goes beyond the unit of liquidity they collect from depositors.
Banks can in fact turn to the money market in order to ﬁnd additional
liquidity they want to invest in further loans to noninstitutional bor-
d) Money market funds
Money market funds are awash with liquidity and can only invest in
short-term debt securities issued by banks.
They are subject to a "VaR equal zero" constraint. Whenever a fund
breaches the constraint it exits the market.
These investors lack specialized skills needed to assess the return on
entrepreneurial projects. Their lending decision is thus taken on the
basis of common knowledge.
3.2 Investment technologies
a) Storage technology
The storage technology is simply cash, that is a 1-period investment
yielding one unit of liquidity per unit of liquidity invested.
b) Deposit Technology
The deposit technology is a 2-period ﬁxed commitment contract that
may differ among regions.
It entitles depositors to get from banks in their region i a constant
amount of liquidity c
at dates t = 1, 2 per unit of liquidity deposited
at the initial date.
c) Entrepreneurial projects
Entrepreneurial projects are homogeneous 2-period investments.
Their return depends solely on the realization of exogenous factors at
the ﬁnal date. The statistical distribution of these random variables can
be inferred, at the initial date, on the basis of historical data available to
At the interim date uncertainty is fully resolved and the return on
entrepreneurial projects at the ﬁnal date is common knowledge.
d) Lending technology
The lending technology is available only to banks. It involves granting
liquidity to noninstitutional borrowers at the initial date, in order to
receive the face value S of the loan two periods later.
The return on entrepreneurial projects being random, noninstitu-
tional borrowers’ ability to repay the loan is stochastic. I assume loans
repayment distributes as ˜s ∼N(¯s , σ
) at the ﬁnal date.
All players share a common prior belief about the realization of the
future uncertain return ˜s on noninstitutional borrowing.
Banks from region i are able to form a posterior belief ¯s
repayment in force of region-speciﬁc skills.
Noninstitutional borrowers’ repayment can be securitized by banks
to issue ABSs. Without any loss of generality and to keep the model
as simple as possible, I assume each unit of liquidity lent by banks is
securitized into one unit of ABS.
e) Repo technology
Banks use their ABSs as collateral to leverage in the money market
using the repo technology. This is a 1-period contract giving banks
the opportunity to borrow liquidity from money market funds against
their pool of loans.
In a repo agreements banks sell their ABSs to a money market fund
in exchange for cash, promising to repurchase them one period later.
When the bank buys back its securities it has to pay a prearranged
This amounts to the ABS market value at the sell date, plus an inter-
est rate r over the liquidity received in the ﬁrst place.
Funds set the interest rate as remuneration for the risk they under-
take. I assume there exist an ABS price p and an interest rate r on repo
transactions such that funds liquidity is sufﬁcient to accommodate ABS
Repo ﬁnancing being short term, banks may roll over the repo agree-
ment at the interim date to obtain further liquidity. However, the new
information available on the realization of noninstitutional loans re-
payment affects the market value of ABS.
Thus, banks’ ability to raise
liquidity through the repo technology varies accordingly.
Depending on the bank cash stock and the new amount of liquidity
available through the repo technology at the interim date, a bank can
be unable to fulﬁll the obligation it has with its counterparty in the
In case their counterparty is unable to repurchase the collateral, funds
refuse to roll over the repo and sell the securities at current market
price, to try and recoup the part of repo repayment that banks liquid-
ity does not cover.
Nevertheless, the ABS market price at the repurchase date can be
insufﬁcient for funds to satisfy their VaR constraint.
In order to protect against this market risk, lenders in the money
market apply a margin h between the market value of pledged assets
and the amount of liquidity they pay for them.
This “haircut”determines the mapping between a bank’s investment
in the lending technology and its pledgeability.
Banks screen entrepreneurial projects in order to forecast the expected
repayment from noninstitutional borrowers. Region-speciﬁc skills per-
mit banks to update the common prior belief E(˜s ) on the basis of infor-
= s + ˜ ε
of the actual ﬁnal repayment s of the lending
technology, where ˜ ε
∼ N(0, σ
), s and ˜ ε
are independent, and errors
are independent across banks.
The uninformed expectation ¯s
= E(˜s ) made by money market funds,
who can not observe any regional signal to update the prior belief, may
therefore differ from the informed expectations ¯s
˜s | f
banks in regions i = 1, ..., n.
Full revelation of the ﬁnal return at the interim date determines an abrupt adjust-
ment in the price of securities backed by the lending technology to its fundamental
value. In future versions of the paper I will focus on the adjustment of this market
value when information is only progressively revealed to market participants.
Banks and depositors in each region share the same signal.
are indeed a ﬁction I make to match investment banks with depositors
that believe in their assessment of the risky return. Banks with a spe-
ciﬁc signal on the risky return compete only with other banks sharing
that same signal - i.e. dealing in the same region - for depositors who
trust that piece of information.
The assumption on matching between banks and depositors in a re-
gion permits to model the banking sector as competitive and yet to
allow banks receiving a relatively bad signal to face positive demand,
although they offer lower future consumption.
Since banks in a region are perfectly competitive and share the same
information and technologies, they are all alike and take the same in-
Thus, to simplify notation, I can look at one representative bank for
every region without any loss of generality.
Relying on the heterogeneity in posterior beliefs, I label regional
banks from the most optimistic bank 1 to the most cautious bank n:
3.4 Time Structure
Initial date: Bank i observes the signal f
and forms its posterior
. It chooses what part λ
of its capital to invest in the storage
technology in order to remunerate depositors at t = 1, and what part
) to invest in the lending technology to get the risky return at
t = 2.
Depositors sharing bank i signal put their unit of liquidity in the
bank to receive an amount of liquidity c
at dates t = 1, 2.
Banks securitize their loans to noninstitutional borrowers and sell
them to money market funds through repo agreements that specify an
interest rate r and a haircut h.
Interimdate: Uncertainty over the enterpreneurial project is resolved
and the repayment by noninstitutional borrowers is known to be s .
In this model a signal can be thought of as a proprietary forecast model or
Bank i must pay depositors the sum c
it speciﬁed in the contract at
the initial date.
Banks must repurchase their securities and may roll over the repo
technology, raising an amount of liquidity that equals the pledgeable
value of their securitized loans at current market price.
Final date: The entrepreneurial project yields its return and banks
receive from noninstitutional borrowers the repayment s on loans.
Banks must repay their debt and give depositors the sum c
committed to at the initial date.
For the sake of clarity, the following timeline summarises the time-
structure of the model:
t = 0
Players form uninformed expectation ¯s
Bank receives private signal f
Bank offers deposit contract c
Customers deposit liquidity
Bank invests into the risky asset S
Bank pledges ABSs in repos
t = 1
Risky return s is public
Bank pays c
Bank repurchases ABSs
Bank rolls over the repo
t = 2
Risky return realizes
Bank pays c
Bank repurchases the ABSs
3.5 ABS pledgeability in the repo market
The pledgeability of bank’s assets is endogenous to the model and is
determined by the need for money market funds to limit the VaR of
Looking at the time series of the entrepreneurial project, funds can
make up the likely scenarios for the ABS price at the repurchase date.
This practice is relevant for risk management purposes, in case the bor-
rowing bank is unable to repay its debt at the rollover date.
A fund in the money market wants to make sure that a borrowing
bank will repay the whole face value of its secured loan, that is the
repurchase price, at the exogenous conﬁdence level α.
For instance, a fund writes the repo contract to lend liquidity against
AAA ABSs, so as not to suffer any loss with 1 −α% probability.
To do so, funds look at the time series of AAAABS market value and
set a haircut h to offset their statistical loss in the α% worst scenario.
Since banks can invest their capital in either risky loans or liquidity,
there is a trade-off between a bank leverage and its credit worthiness.
In fact, the ability of a money market fund to recoup the full value of
its credit in bad scenarios decreases with the share of capital the bank
invested in the risky technology.
Depending on the exposure q the bank has to noninstitutional bor-
rowers, a lender in the money market sets the haircut h on repo such
(1 −v) ≥ q p
(1 −h)(1 + r ). (1)
Where λ is the amount of a bank’s initial capital invested in the stor-
age technology, q is the number of ABS issued by the bank, p
market value of the security, r is the repo rate and v is the percentage
decrease of the ABS price in the α% worst scenario, according to the
unconditional probability distribution of ˜s .
On the left hand side of the inequality is the sum of the liquidity λ
the bank decided to hold at the interim date and the market value, in
the worst α% scenario, of the portfolio of assets it pledges.
On the right hand side is the face value of repo debt at the interim
The solution to inequality (1) gives a value for the minimum hair-
cut h that depends on r , v, p and on the bank’s portfolio allocation
between storage and lending technologies:
r +v −
1 + r
Funds face a trade off between protecting themselves from losses by
applying a higher haircut and earning interests on a larger amount of
Thus, the optimal haircut lenders can apply is the lowest value al-
lowed by inequality (2) - i.e. the same formula with equals sign.
When claims on the 2-period investment are offered as collateral in
the repo market each bank can ultimately borrow, at any date t , an
amount of liquidity speciﬁed by the pledgeability function
(λ, r, v, p
) = (1 −h)q p
r +v −
1 + r
Lemma 1 As the bank risky investment q increases, a lower percentage
of the collateral market value is pledgeable in repo agreements with money
market funds. The gap between the two values, the haircut, increases with
the statistical asset depreciation v.
Proof. The derivative of the pledgeable value per unit of market value
with respect to the size of the risky investment is
∂ (1 −h)
(1 + r )
The haircut moves with the statistical percentage change of the collateral
market value according to the partial derivative
1 + r
Figure 1 shows the shape of the pledgeability function for some val-
ues of v, when all other parameters are held constant.
3.6 Investment and contract design
Each competitive bank wants to maximize its future payments to de-
positors choosing the optimal portion of capital (1 −λ) to be invested
in the lending technology.
As the exposure to the risky technology is chosen, the current price
of ABSs and its past volatility, together with the repo rate, determine
through equality (3) the pledgeable value of the bank portfolio of loans.
Thus, a bank leverage is endogenously determined by its expectation
on the risky return.
The bank’s budget constraint at the initial date is
q ≤ (1 −λ) +q p
where q are the units of liquidity it lends to noninstitutional borrow-
ers, (1 −λ) is the capital allocated to lending activity, and q p
(1 −h) is
the amount of liquidity the bank can borrow by pledging its ABSs at
current market price.
The maximum amount of money the bank lends to its noninstitu-
tional borrowers - i.e. the number of ABSs it issues - is then
1 − p
The amount of loans a bank can issue on the basis of its portfolio
allocation is given, together with the haircut on its repo, by the simul-
taneous solution to inequality (2) with equals sign and of equality (4):
Thus, depending on the optimal portfolio allocation (λ, 1 −λ), a bank
will issue an amount of ﬁnancing to noninstitutional investors
1 + r (1 −λ)
(1 + r ) − p
and it is applied by investors a margin on repo transactions
(1 −λ)(r +v) +λ( p
(1 + r (1 −λ))
In order for the portfolio allocation to be non trivial for banks, it is
necessary that the money market be concerned with the fulﬁlment of
the VaR constraint.
If that was not the case banks would be free to leverage without a
limit. They could raise an inﬁnite amount of liquidity to invest in the
lending technology, regardless of the share of deposits invested in loans.
Thus, the marginal return the liquidity invested in the risky asset is
expected to yield in the α% worst scenario has to be lower than the
repayment to be made for the same unit of liquidity in the money mar-
For this reason, throughout the model it is assumed that
(1 + r ) > p
(1 −v). (7)
This assumption ensures that the market value of pledged collateral
may be insufﬁcient in order for lenders to limit their potential losses
under the VaR level at the rollover date. Thus, the following result
Lemma 2 When lenders in repo transactions are concerned with the risk
of the borrowing bank being unable to repay its debt, the haircut they apply
increases with the bank investment in the lending technology.
Proof. From equation 6,
(1 −v) −(1 + r )
(λr −(1 + r ))
Since the value of the haircut is decreasing in the portion of capital de-
voted to the riskless technology, it increases with the risky position of the
Banks optimal decision problem can be solved by backward induc-
Bank i observes a signal f
and chooses to invest a portion (1−λ
its deposits in the lending technology at the initial date.
Equality (5) determines the investment q
in the lending technology
bank i affords using the leverage available through the repo technology.
The bank borrows q
(1 − h
) from money market funds and lends
this external capital, plus its investment (1 −λ
), to noninstitutional
The bank is left with liquidity λ it carries on to period 1, when the
repayment to money market investors is q
)(1 + r ).
Bank i has a posterior belief on the repayment ¯s
˜s | f
noninstitutional borrowers. Thus, at the initial date, it chose the opti-
mal allocation (λ
, 1 −λ
) expecting the value of its ABSs to change at
the interim date by
Considering the expected price change, bank i expects to be able to
raise from the money market at time 1, when the repo agreement has
to be rolled over, an amount of liquidity
The investment in the storage technology at initial date, together with
the difference between the liquidity borrowed and repaid to money
market funds at date 1, are the liquidity bank i has available to pay its
depositors the ﬁrst periodic installment c
Thus, bank i enters the ﬁnal period with an amount of liquidity
− r )(1 −h
At the ﬁnal date the entrepreneurial project yields its return and the
lending technology pays the return that bank i expected at the initial
date to be ¯s
The bank has to repay an amount q
)(1+r ) to money
market funds, and depositors must be paid their second installment c
At the ﬁnal date bank i has then an amount of liquidity
)(1+r ) +q
Since bank i wants to maximize the payment to its depositors, no liq-
uidity is to be left in the bank at the end of the contract. Furthermore,
money market funds must take their optimal decision and all players
satisfy their solvency constraints in expected terms.
Thus, bank i decision problem at the initial date is:
− r )(1 −h
)(1 + r ))
s .t . c
− r )(1 −h
)(r +v) +λ
(1 + r (1 −λ
1 + r (1 −λ
(1 + r ) − p
Equation (11) stems from the condition that at the end of the ﬁnal
period the bank must not hold any spare liquidity. Inequality (12) is the
bank budget constraint derived from (9) and ensures that, at the end of
period t = 1, the bank has sufﬁcient liquidity to pay its depositors.
Constraints (13) and (14) come from the optimization problem of
money market investors (6) and from bank’s leveraging at the initial
date (5) respectively.
The optimal portfolio allocation is trivial when solvency constraint
(12) is not binding.
If this is the case, the optimization problemhas a bang-bang solution.
The optimal portfolio allocation sees bank i investing all its deposits
in the risky lending technology - i.e. λ
= 0 - when its a posterior
is high enough to offset the costs of collateralized borrowing
stemming from r and v.
If instead the bank expects the loans repayment to be relatively low
it invests everything in cash, and λ
If the solvency constraint is binding, the optimal portfolio allocation
is given by
((1 + r )( p
(1 −v) +¯s
)(1 −v) +¯s
((1 + r )(1 + p
v) −( p
Lemma 3 Banks whose expectation on ¯s
is more biased towards opti-
mistic results choose higher exposure to the risky investment. They commit
to higher periodical payments to their depositors.
Proof. Bank i optimal investment in the storage technology is lower, the
higher is the expected return on the risky investment:
(2 + r )(1 −v)((1 + r ) − p
+ r s
r v +2p
v + p
(1 + r ) − p
(1 −v) >0
under the assumption, made in (7), that lenders be concerned with the re-
payment of their ﬁnancing.
Thus, for high expected values of the risky return, a bigger portion of the
bank’s capital is devoted to the risky asset.
The amount of liquidity c
bank i commits to pay its depositors at each
date is then given by (11), once the optimal value λ
is determined. The
periodic payment bank i commits to pay its depositors increases with the
optimal risky investment:
r (( p
(1 −v) −s
(1 + p
((1 + r ) − p
Since the optimal risky investment increases with its expected return, banks
with higher expectation ¯s
commit to higher periodic payments to their de-
4 Effect of systemic shock
At date t = 1 the systemic shock is realised and the risky return s is
If s <¯s
, the return of the risky asset is lower than its most optimistic
expected value at t = 0, and one or more optimistic banks are forced to
violate their contracts.
Banks j is unable to abide by the contract whenever ¯s
> s . If this is
the case, in fact:
− r )(1 −h
)(1 + r ))
− r )(1 −h
(s − p
)(1 + r ))
is the change in ABS price due to the interim information on its ﬁnal
The value for c
is therefore higher than the liquidity bank j has
available after the shock hit.
The unexpected gain G
bank j realizes is the liquidity it has in excess
once depositors’ claims are fulﬁlled:
r (1 −v))(s −¯s
)(1 −v) + s
(1 − p
+(1 + r )(1 + p
Although the issue is not addressed in the present paper, the bias of
banks evaluation can well depend on their governance: ﬁnancial in-
stitution investing on the basis of higher expectations about the risky
investment enjoy greater competitiveness in the banking industry but
bear more risk.
Therefore, capital structure, managerial incentives and banks risk
management play a role in determining what scenario theeconomy-
wide banking industry faces.
Assuming for the sake of simplicity that the economy is divided in
only two regions, three different scenarios can arise.
The relevant scenario depends on the bias each bank had towards
more optimistic or pessimistic values.
4.1 Scenario 1: considerate banking sector
In the ﬁrst scenario, all banks made a correct or pessimistic estimate of
s . Thus, at the initial date they were able to keep a sufﬁcient amount
of liquidity to escape bankruptcy afterwards:
4.2 Scenario 2: inconsiderate banking sector
The second scenario arises if at date t = 0 both banks had incentive to
overexpose their portfolio to the risky investment.
The whole system goes bankrupt, and there is no way to collect among
banks the sum needed to face the systemic impact of the shock. In this
scenario, public intervention is necessary to avoid the whole banking
sector from shutting down.
However, every single bank goes bankrupt in this scenario as a con-
sequence of its wrong investment in the risky technology. There is no
contagion channel involved in the crisis.
4.3 Scenario 3: idiosyncratic effect of systemic shock
In the third scenario, the difference among banks ex-post beliefs allows
the shock to produce an idiosyncratic impact. The optimistic bank 1
is insolvent, whereas bank’s 2 bias towards a more cautious evaluation
allows it to face the shock without going bankrupt.
This is the scenario the model is focused on: the idiosyncratic impact
of a systemic shock whereby
The reason why this paper focuses on scenario 3 rather than scenario 2
Primarily, the considerate - or pessimistic - bank correctly evaluated
the return on risky technology. Yet, as I shall show, it can be forced to
bankruptcy by the overvaluation made by the other bank.
Secondly, the banking industry may have enough liquidity to cope
with the crisis, in scenario 3, without need for intervention by the gov-
ernment. This possibility is brieﬂy investigated in Section 6 for its pol-
Under scenario 3 only the optimistic bank is insolvent. Bank 2 hav-
ing set up lower-proﬁle deposit contracts, the effect of the shock on its
ability to pay is an excess of liquidity available at the ﬁnal date, when
the return s - for bank 2 unexpectedly high - is paid by noninstitutional
Yet, the pledgeable value of bank 2 assets depends on the price the
ABS is traded for.
If the interim information on the risky return is good enough for
lenders of the insolvent banks to recoup the face value of their cred-
its at the new ABS fundamental value, the amount of liquidity that is
available for lending does not vary in the model. The collateral in repo
agreement is priced efﬁciently.
Solvent banks can roll over their debt and fulﬁll their commitment
until loans are repaid at the ﬁnal date.
However, when the interim information is negative - i.e. s < p
lenders can breach their VAR limit. If this is the case, a lender "breaks
the buck" and can not participate to the money market anymore.
Thus, if the new information on the liquidation value of the risky
asset is such that
the liquidity that is available in the money market decreases because
lenders of insolvent banks face losses above their VaR limit. This re-
sults in "cash-in-the-market" pricing for the securities pledged in repo
The issuing of ABSs being chosen by banks at the initial date, the
number of traded securities at the interim date does not vary. The total
For a comprehensive treatment of cash-in-the-market pricing see Allen and Gale
supply of the pledgeable asset is
Nevertheless, the liquidity that is available in the money market to
trade the risky asset decreases because some investors left the money
The available liquidity L amounts to the repayment funds received
from solvent banks at the end of the ﬁrst repo:
L = p
where k is the number of insolvent banks.
Only lenders of the n −k less optimistic banks in the industry sur-
vived in the money market.
Thus, the maximum price ˆp money market investors are able to pay
for the pledgeable asset at the interim date is
that is lower than the asset fundamental value if
The higher the risky investment of the k overoptimistic banks is, the
more likely the price of the pledgeable asset is to be below its funda-
mental value at the interim date.
Lemma 4 The difference between fundamental value of the risky asset
and its price at the interim date increases with the position held by overop-
timistic banks, in proportion to the total supply.
Proof. From (17), the underpricing at the interim date is
Hence, the higher is the holding of the k inconsiderate banks relatively to
the total quantity of risky assets issued at the initial date, the higher is the
difference between the fundamental value of the asset and its cash-in-the-
Corollary 5 The pessimistic misevaluation made by solvent banks at the
initial date limits the depreciation of the asset at the interim date.
This result is in line with the too-big-too-fail doctrine: the impact of
ﬁre sales depending on the amount of assets held by insolvent banks
relatively to the whole supply, the size of the insolvent institution is
critical in determining the impact of the misevaluation on the banking
More optimistic banks are precisely those holding bigger quantities
of the pledgeable asset. Thus, the event of a sudden liquidation of their
whole portfolio of risky assets is likely to put their market value under
This calls a solvent bank for strategic concerns.
On the one hand, if assets of the optimistic banks are liquidated at
ﬁre-sale price, the pessimistic banks has the opportunity to buy the
assets for a lower price p
On the other hand, by paying a very low price, the solvent bank
suffers a decrease in the value it is able to pledge to get liquidity in the
Thus, as I shall show in the following section, the considerate bank
can go bankrupt even though the fundamental value of the investment
is greater than it expected at the initial date.
I start by showing a benchmark case, labeled L, where the amount of
liquidity banks can borrow by pledging their assets does not change
over time. Instead of relying on short-term funding, banks are forced
to sign at the initial date long-term repo agreements.
In this case, banks only “bet”on the ﬁnal return of the risky invest-
The repo market for liquidity here is not a way for banks to increase
the return to their investors, relying on a future increase of collateral
market value. Banks only look at the repayment from the lending tech-
nology at the ﬁnal date.
Hence, bank i ’s objective function doesn’t take into account the ef-
fect of asset appreciation (depreciation) on its ability to borrow. The
portfolio allocation problem is the same described by equations 11-14,
now with δ
This yields a result for the optimal liquidity
(1 −v) −¯s
(1 −v) −(2 + r + r¯s
together with an investment in the lending technology and issuing of
2 + r
(1 −v) −(2 + r + r¯s
The gain to the bank at the end of the second period is then
(2 + r )(¯s
(1 −v) −(2 + r + r¯s
Noninstitutional lending being nonnegative, bank i ’s gain is positive
whenever its initial expectation on the risky return is lower than its
If banks are given the opportunity to trade bank 1 assets at cash-in-
the-market price p
, bank gain becomes
(2 + r )(¯s
(1 −v) −(2 + r + r¯s
(2 + r )(s − p
2[(1 + r ) − p
(1 −v)] + r (¯s
labels the ex post gain in the benchmark case with trade,
is the optimistic bank expectation on the risky return.
Proposition 1 Without interim rollover, the repo market does not act as
channel for contagion from inconsiderate banks to other borrowers in the
Moreover, the fact that misevaluating banks go bankrupt and their port-
folios are liquidated is always beneﬁcial to solvent banks.
Proof. The additional gain is given by the difference between equalities
(20) and (19):
(2 + r )(s − p
2[(1 + r ) − p
(1 −v)] + r (¯s
The denominator is positive under the assumption made in equation (7)
noticing that for ¯s
<1 a bank would not invest in the risky technology.
Thus, solvent banks gain from insolvencies resulting in the market under-
pricing ABSs at the interim date.
If the pledgeability of an asset is not affected by underpricing at the
interim date, the fact that a distressed institution suddenly offers its
whole portfolio of assets is beneﬁcial to banks that took their invest-
ment decision over a more considerate evaluation.
The result is in line with those by Acharya, Gale and Yorulmazer
(2010) and Carlin, Lobo and Viswanathan (2007). Banks have incentive
to act as vultures and hoard liquidity with the expectation of using it in
the near future to buy assets with positive return at ﬁre sale price.
When the market prices the pledgeable asset on the basis of its ex-
pected return, there is no contagion in the banking sector even though
banks have to roll over their debt at the interim date. On the contrary,
considerate banks can raise more liquidity than they expected at the
time of their portfolio allocation.
Banks with a pessimistic expectation on the return end up at the
interim date with some spare liquidity given by equation (16).
On top of that, they have the funding needed to buy some assets
previously owned by the insolvent optimistic banks.
As long as the asset is priced at its fundamental value - that is public
information at the interim date - solvent banks pay an ABS exactly
what they are going to receive from it at the ﬁnal period. Thus, they
do not gain nor lose anything from trading.
However, if the market prices efﬁciently the asset, there is no room
for predatory liquidity hoarding in the ﬁrst place.
Under the speciﬁcation of this model a contagion channel is at work
when banks roll over their debt at the interim date. When the market
prices pledgeable assets inefﬁciently, banks with a correct belief on the
risky return go bankrupt.
The effect of asset depreciation on the liquidity of solvent banks chal-
lenges previous results on liquidity hoarding and changes the incentives
of ﬁnancial institutions in the midst of a crisis.
If at the interim date, following bankruptcy of the optimistic bank,
the market price falls to p
< ¯ s
, the ﬁnal amount of liquidity bank 2
has available is higher than needed to honour its commitments.
Under cash-in-the-market pricing, labeled AG, this yields considerate
bank 2 a ﬁnal unexpected amount of spare liquidity
r ( p
(1 −v) + ¯ s
)( ¯ s
) + ¯ s
(2 + r )(s − ¯ s
( ¯ s
r )(1 −v) + ¯ s
−1) −(1 + r ) ¯ s
(1 + p
that is always positive.
Pessimistic banks have in fact the opportunity to buy a remunerative
asset at low price and, having less pledgeable value at the interim date,
need pay a lower amount of interests in the following period.
Nevertheless bank 2 may fail at the interim date because it is unable
to raise the liquidity needed to remunerate its investors and roll over
the ﬁrst repo.
Proposition 2 If ﬁre sales lower the price of pledgeable assets below the
liquidation value expected by solvent banks, the latter go bankrupt.
Proof. From equation (12), at the interim date
− r )(1 −h
whilst the liquidity available to the bank at that date is
− r )(1 −h
is the price change of the pledgeable asset in case of cash-in-the-market pric-
ing. The liquidity available to the bank is not sufﬁcient to cover its needs -
that is, L
Thus, from equations 8 and 22, the amount of liquidity c
bank has available at t = 1 is lower than needed to fulﬁll depositors’ and
lenders’ claims whenever p
< ¯ s
The condition that considerate banks had an expectation on the total
return of the risky asset higher than its cash-in-the-market price at the
interim date is sufﬁcient for the liquidity crisis to unleash.
This happens notwithstanding the fundamental value of considerate
banks portfolio is greater than necessary to ensure their solvency.
The insolvency of misevaluating banks has thus the potential to spread
as liquidity crisis endangering otherwise solvent institutions.
6 Policy implications
Section 5 showed that an institution can be driven to bankruptcy re-
gardless of the fundamental value of its portfolio, if the pledgeable asset
depreciates sufﬁciently to be lower than the expectation of considerate
banks on its ﬁnal return.
The most optimistic bank fails as a consequence of the misevaluation
it made the optimal risky investment at the initial date. The trouble of
the ﬁrst failing bank may spread to other institutions in the banking
sector because of indirect linkages through the repo market for liquid-
The fall in the market value of banks portfolio is the only conta-
gion channel in the model. A government can prevent the mistake
of some banks from becoming a systemic liquidity crisis by inﬂating
banks pledgeable value. It can do so either by accepting the asset in liq-
uidation as collateral for public lending, or by keeping its market price
to a value that is compatible with the liquidity needs of solvent banks.
However, the government issuing ﬁnancing to private ﬁnancial insti-
tution is a source of moral hazard for the industry and can come at a
If the government does not intervene, banks are left to ﬁght alone
against the contagion. In the paper by Acharya, Gromb and Yorul-
mazer (2009) the outcome is deadly for the banking industry. Banks
worsen the crisis by strategically providing insufﬁcient liquidity to in-
stitutions in needs, in order to induce ﬁre sales and buy cheap assets.
In the model of originate-to-distribute banking developed here, the
outcome is far more desirable, because banks are hurt by the default of
In what follows, I perform a preliminary analysis of the policy im-
plications resulting from asset-side contagion through the repo market.
This exercise is done neglecting the issue of coordination within n >2
banks and the comparison with different public intervention strategies.
Both topics are left to future research.
Proposition 3 Solvent banks have the opportunity to bail out themselves
by paying the asset of insolvent banks an inﬂated price b > p
(1 −h) ¯ s
)s −h(1 + r )q
(1 −h)(1 + r )(q
Proof. In order to avoid contagion, solvent banks must clear the market
for the pledgeable asset at a bailout price b that allows themselves to bor-
row, against their collateral, the amount of liquidity needed to satisfy the
The solvency constraint with the bailout price at the interim date is
(1 −h) p
(1 + r ) +q
(1 −h) ¯ s
≤ λ −q
(1 −h) p
(1 + r ) +(q
)(1 −h)b −q
On the left hand side of the inequality is the amount of liquidity consider-
ate banks need to hold after the bailout, in order to fulﬁll the commitments
they signed at the initial date.
On the right hand side is the liquidity they will be holding after the
bailout, given a new market price b for the pledgeable asset.
This gives a condition on the bailout price
(1 −h) ¯ s
Thus, the bailout price must be high enough for the increase in pledgeable
value of the initial portfolio to offset the cost of the new purchase.
However, a high pledgeable value at the interim date translates into a
high interest to be paid at the ﬁnal date. The solvency constraint at the
ﬁnal date is
−(1 + r )(1 −h)q
+q1)s −(1 + r )(1 −h)(q
Once more, on the left hand side of the inequality is the amount of liquid-
ity considerate banks need to hold after the bailout in order to fulﬁll the
commitments they signed at the initial date.
On the right hand side is the liquidity they will be holding after the
bailout. In force of the realization of the risky return this would be higher
However, the bank has to pay additional interests for the liquidity bor-
rowed at the interim date to bail out inconsiderate banks.
To satisfy the solvency constraint at the ﬁnal date, the bailout price res-
cuing banks can afford at the interim date is
)s −h(1 + r )q
(1 −h)(1 + r )(q
As mentioned before, this result contrasts with the ﬁndings of Acharya
et al. (2008) and Carlin et al. (2007). The threat of contagion through
the repo market prevents banks from adopting vulture-like strategies.
Beside the potential for self-bailout found under the feasibility con-
dition (23) in Scenario 3, this result makes public intervention cheaper.
Out of the feasibility condition speciﬁed by Proposition 3 in fact, the
policy implication of the model is more general: when the government
commits not to inject in the banking industry an amount of liquidity
higher than what institutions need to stop the contagion, the direct
threat a systemic crisis constitutes to solvent institutions induces the
latter to carry a partial public intervention.
Corollary 6 When condition (23) is not satisﬁed, banks have still incen-
tive to join the government in an effort to prevent the contagion of insol-
vent banks bankruptcy to the banking sector.
Contagion is thus avoided with the government committing to exert the
lowest effort compatible with the industry succeeding to prevent a liquidity
Corollary 6 ensures that even in scenario 2, where there is not enough
spare liquidity in the banking sector to remedy the wrong portfolio
allocation chosen by misevaluating institutions, solvent banks do not
hoard the liquidity injected by the government to sustain ABS price.
7 Numeric example
Consider an economy where agents need to borrow money in order to
buy a home.
Each borrower needs one unit of liquidity and are able to repay it
only two periods later.
Banks can issue the loan and simultaneously borrow liquidity in re-
purchase agreements, credits with the home buyers being the securi-
tized collateral for the transaction.
One period later, public data on mortgage delinquency at the ﬁnal
period are being released.
The time series of the market value for the relevant class of Home
Equity ABS shows that in the 1% worst scenario the security had lost
4.8631% of its value during one period.
Financial markets currently price the ABS 1.021. Thus, under the
assumption of no discounting, the market expected return from the
mortgage is 2.1% after the two periods. The repo rate for one period is
Assume there are two regions in the economy, each with one bank
and a continuum of home buyers.
Bank in region 1 is optimistic about the return on mortgages. Ac-
cording to its forecast, the vast majority of borrowers will be able to
repay their debt at the ﬁnal date.
Bank 1 expects the data on delinquency being released the following
period to conﬁrm its belief that the actual return on loans will be 2.5%.
Bank 2 is less optimistic. According to its forecast model on mortgage
delinquency, the return of the loans will be only 1.5%.
The optimal portfolio allocation for Bank 1 is to invest the 21% of
its capital in loans to home buyers. It faces a haircut of 2.65% and is
able to promise its depositors two periodic payments of 0.89 each - i.e.
a 79% return.
Bank 2 being less optimistic on the realization of the risky return,
it only invests the 5% of its portfolio in the risky asset and promises
its depositors a periodic payment of 0.72 that corresponds to a 44%
One period later, the public report shows that the return on loans
will be 2%.
The contract bank 1 proposed to its investors is unfeasible. In pe-
riod 2 the bank has only 0.69 units of liquidity to pay them. Thus,
bank 1 will be insolvent at time 2 and lenders in the money market are
unwilling to roll over its debt at the interim period.
The outcome is much different for bank 2. New information shows
that it has a surplus of liquidity at the ﬁnal period. The risky return
being now known to be 2%, the present value of its assets is more than
sufﬁcient to roll over its debt.
Moreover, the high ﬁnal return will leave the bank with some spare
liquidity available after all commitments are fulﬁlled (Proposition 1).
Weekly data on Barclays ABS Home Equity for the period Jan 2000-Oct 2007
According to Gorton and Metrick (2009), in the ﬁrst half of 2007 AAA asset-
backed securities traded below LIBOR.
However, the pledgeable value of collateral depending on its market
value, bank 2 ability to roll over its debt is endangered by the losses
bank 1 determined to money market investors.
Since in this example there are only two banks, the default by one in-
stitution has the effect of decreasing the market price of the pledgeable
asset by a great extent.
According to the model, the cash-in-the-market pricing of the ABS
determines a new market value of 0.4992.
The pledgeable value of its collateral being below its initial expecta-
tion, bank 2 lacks the liquidity necessary to repay the debt taken out at
the initial date.
This happens notwithstanding the f undamental value of its invest-
ment is higher than needed for its solvency (Proposition 2).
The only way bank 2 has to avoid defaulting is to buy bank 1 assets
for an artiﬁcially high price.
With the values posited in this numerical example a self-bailout is not
feasible. However, it is sufﬁcient that the information available at the
interim date on mortgage delinquency determined a return on loans of
2.2% to change this prediction.
Bank 2 can then pay bank 1 ABSs a price b ≥ 1.0382, so as to have
the liquidity necessary at time 1 to repay the initial debt. At the same
time, this bailout price has to be b ≤1.0438 in order for the bank to be
able to repay its commitment at the ﬁnal date (Proposition 3).
With the values assumed in the new example, the outcome of the
model is overly reassuring. Although the insolvency of some banks can
lead bankrupt otherwise solvent banks, the latter have the opportunity
to bail out themselves by buying the assets being liquidated.
With a the original set of values the feasibility condition in Proposi-
tion 3 is not satisﬁed, but the result is still hopeful for the stability of
Bank 2 has not enough liquidity available to clear the market for the
ABS at a sufﬁciently high price at the interim date to avoid bankruptcy,
thus public intervention is necessary to prevent a liquidity crisis to un-
However, since solvent banks have a direct interest in clearing the
market at a sufﬁciently high price, under the results of the model public
intervention comes to a lower cost than expected otherwise.
In fact, the government has the opportunity to prevent the conta-
gion by buying only part of the assets being liquidated by the insolvent
Bank 2 has then incentive to participate to the bailout with all its
spare liquidity, buying at the same bailout price the remaining assets to
The numeric example was deliberately designed to show the results
of the model when those are less likely to have effect. In fact, the cir-
cumstance that more than half of the whole capital of the banking in-
dustry was invested in mispriced assets is very unlikely to arise.
When the overoptimistic investment is conﬁned to a smaller portion
of the capital of the banking sector, the contagion channel is still in
However, the amount of private spare liquidity held by banks willing
to help the government is greater than in the example shown above.
This translates into the government having to inject less liquidity to
sustain the price of pledgeable assets and stop the contagion.
8 Concluding remarks
Far from solving the debate on what allowed the shock in the US sub-
prime mortgage delinquency rate in 2007 to spread worldwide with
such a terriﬁc effect, this paper shades a new light on the possibility
for the mistake of some institutions to precipitate a systemic liquidity
Neglecting the issue of early diers, I focused on the misevaluation
of opaque ﬁnancial derivatives as a source of the crisis. Since limited
convertibility at the interim date is optimal to depositors, there are no
bank runs in the model.
Moreover, because the model rules out crossed claims among banks,
there is no room for domino-contagion.
The main result of the paper is that a market providing liquidity
against collateral may act as a channel for contagion.
Banks are only indirectly linked one to each other through the repo market. Thus,
differently from what happens in domino models, a bank is unable to protect from
contagion by mean of an appropriate choice of its counterparty.
The composite effect of opaque assets and short term collateralized
borrowing is able to propagate the negative effect of asset mispricing
by any overoptimistic institution to the whole banking sector.
This new channel adds to the domino effect and to the change in
haircut that are well known in the previous literature.
Differently from what found in previous papers on predatory liquid-
ity hoarding, banks have no incentive to adopt vulture-like strategies.
The existence of a market for collateralized borrowing introduces a
strategic interdependence that limits the advantage solvent banks can
gain from the bankruptcy of their competitors.
When banks rely on the repo market for much of their liquidity
needs, the additional return they get from cheap collateral is offset by
the amount of liquidity they must give up on the money market.
The decrease in asset value can thus make solvent banks illiquid, and
lead them bankrupt because of their inability to meet the solvency con-
Three stylised facts about the Subprime crisis are consistent with the
present model: banks-SPVs relied on collateralized borrowing against
opaque assets to increase their leverage, a negative shock on mortgage-
backed securities return reduced the value of those securities, and bank-
ing institutions had difﬁculties to fund their periodical payments.
Rather than assuming a surge in haircut to give account of the after-
math of the 2007-2009 crisis, the value of that margin is derived endoge-
nously in the model. This paves the way to a more general analysis of
liquidity funding in the banking sector.
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