The Joint Determination of Haircuts and Interest Rates for Collateralized Loans in Shadow Banking

This paper examines the joint determination of haircuts and interest rates for collateralized loans in shadow banking within a general equilibrium model. Three results emerge. First, higher downside quality (the distribution of future collateral payoffs below the debt face value) reduces haircuts only under certain conditions, whereas higher upside quality (the distribution of future collateral payoffs above the debt face value) always increases them. Second, the relative insensitivity of interest rates to shocks, compared with haircuts, occurs when shocks affect only the upside collateral quality and can also arise endogenously, with changes in haircuts amplified and changes in interest rates dampened. Third, when depositors’ saving needs increase, interest rates unexpectedly rise while haircut requirements are relaxed. The same effects occur when banks’ collateral supply shrinks.

This paper was accepted by Bruno Biais, finance.

Supplemental Material: The online appendix is available at https://doi.org/10.1287/mnsc.2022.00541.