Risky Financial Collateral, Firm Heterogeneity, and the Impact of Eligibility Requirements

Abstract

This paper studies how endogenous firm responses amplify the impact of central bank eligibility requirements on collateral supply and quality. Amplification arises, because banks increase demand for eligible bonds and firms increase bond issuance and default risk in response. We analyze these effects in a heterogeneous firm model with endogenous default and eligibility premia. Using a calibration to European data, we find that, in normal times, firm responses account for 30% of the total increase in collateral supply and 15% of the decrease in collateral quality. If fundamental risk is high, these numbers decline to 15% and 11%, respectively.