The Fragility of Short-Term Secured Funding Markets

Abstract

This paper develops a model of financial institutions that borrow short-term and invest into long-term assets that can be traded on frictionless markets. Because these financial intermediaries perform maturity transformation, they are subject to potential runs. We derive distinct liquidity, collateral, and asset liquidation constraints, which determine whether a run can occur as a result of changing market expectations. We show that the extent to which borrowers can ward off an individual run depends on whether it has sufficient liquidity, collateral, and asset liquidation capacity. These determinants are endogenous and depend on borrower specific fundamentals such as leverage, productivity, size, and asset market activity. Moreover, systemic runs are possible if shocks to the valuation of collateral held by outside investors are sufficiently strong and uniform.