The impossibility of effective enforcement mechanisms in collateralized credit markets

Abstract

We analyze the possibility of the simultaneous presence of two key features in price-taking sequential economies: collateralized credit operations and effective additional enforcement mechanisms, i.e. those implying payments besides the value of collateral guarantees. We show that these additional mechanisms, instead of strengthening, actually weaken the restrictions that collateral places on borrowing. In fact, when collateral requirements are not large enough in relation to the effectiveness of the additional mechanisms, lenders anticipate payments exceeding the value of the collateral requirements. Thus, by nonarbitrage, they lend more than the value of these guarantees. In turn, in the absence of other market frictions such as borrowing constraints, agents may indefinitely postpone the payment of their debts, implying the collapse of the agent’s maximization problem and of such credit markets.