Collateral Reuse and Financial Stability

The isolated effects of collateral reuse on financial stability are ambiguous and understudied. While greater collateral reuse can guarantee more payments with fewer assets, it can also increase the exposure to potential drops in collateral price. To analyze these tradeoffs, we develop a financial network model with endogenous asset pricing, multiple equilibria, and equilibrium selection. We find that more collateral reuse decreases the likelihood of the worst equilibrium (crisis), with varying effects depending on the network structure. Therefore, collateral reuse can unambiguously improve financial stability for a fixed degree of risk-taking behavior. However, with endogenous risk-taking, we show that a higher degree of collateral reuse can worsen financial stability through greater risk-taking. As a result, while crises may occur less frequently, their severity would increase, leading to a lower social surplus during crises.