The impact of securities financing arrangements on the allocation of capital

Securities financing arrangements (SFA) allow investors to use short-term credit to leverage their investments in securities. Largely ignored by economists prior to the financial crisis of 2007–2008, research since that time has implicated SFA in creating financial instability. The creditors in the agreements have been compared to bank depositors who can create a liquidity crisis by withdrawing their funds. While not denying the instability problem, the focus of this paper is the effect of SFA on the allocation of capital in the real economy. I provide institutional context by tracing the evolution of SFA over the past four decades and relate the evolution to legislative changes initiated by the financial sector. Next, I outline a model to elucidate the essential features of a system of securitized finance that relies on SFA. With the aid of the model, I analyze the incentives inherent in the system and show how they can lead to a distortion in the allocation of capital. I conclude that SFA have served the interests of the financial community, but that they have not always delivered improvements to the wider economy.