The Rising Risks and Roles of Financial Collateral

The Rising Risks and Roles of Financial Collateral

This article by David Murphy was originally published in Butterworths Journal of International Banking and Financial Law (JBFIL), under the title 'The risks and roles of Financial Collateral'. In it David Murphy reviews the principal risks that collateralisation brings both to the parties involved and to the financial system as a whole.

Introduction

Collateral has a central role in the post-crisis financial system. Unsecured interbank markets have declined, so secured funding transactions whether private or with central banks have become the most important conduit of liquidity to the financial system. At the same time, collateral became a key feature of the post-crisis regulatory reforms: it will be mandatory for many bilateral OTC derivatives and is already required for centrally cleared transactions. This ubiquity has led to concern as to whether there is enough collateral to meet all the roles it must play. In this article we review the key features of secured transactions, setting out the principal risks that collateralisation brings both to the parties involved and to the system. This discussion is illustrated by two of the key failures during the crisis, AIG and Lehman Brothers. We also examine the structural features of the secured financing market, noting in particular an important lesson to be gleaned from the size of large US dollar tri-party repo portfolios.

We then turn to the post-crisis financial system in detail, highlighting the role of collateral in the principal reforms made to wholesale markets. The paper ends with a discussion of the risk profile of the financial system that will result once these reform efforts are complete.

1. How collateral works

Financial collateral is typically used when one party has (or may in the future have) a credit exposure to another which is not mutually acceptable. The lender may not wish to have substantial exposure to non-performance by its counterparty. The exposure is mitigated by means of a financial asset. This asset, the collateral, is posted for the benefit of the party owed. If we assume that

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