DP10505 | Insecure Debt

Publication Date

22/03/2015

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Abstract

We study bank funding choices under asset liquidity risk and a realistic bankruptcy process, where illiquid assets are shared among all unpaid creditors. Repo debt is cheap and stable but shifts risk to unsecured debt. In the unique equilibrium, repo has a nonmonotonic effect. Runs are rare when unpledged liquid assets are abundant, rise as more repo funding shifts risk, and ultimately fall as less liquidity is available for early withdrawals. The socially optimal choice minimizes inefficient runs by limiting repo or by subsidizing a high rollover yield on unsecured debt. The private choice uses more repo and a lower rollover reward, trading off runs against cheaper funding