Collateral Composition, Diversification Risk and Systematically Important Merchant Banks

We study the impact of collateral diversification by non-financial firms on systemic risk in a general equilibrium model with standard production functions and mixed debt-equity financing. Systemic risk comes about as soon as firms diversify their collateral by holding claims on a big wholesale (merchant) bank whose asset side includes claims on the same producer set. The merchant bank sector proves to be fragile (has a short distance to default) regardless of competition. In this setting, the policy response consisting in official guarantees for the merchant bank liabilities entails considerable government loss risk. An alternative without the need of public sector involvement is to encourage systemically important merchant banks to introduce a simple bail-in mechanism by restricting their liabilities to contingent convertible bonds. This direction of regulatory policies can be particularly relevant for containment of systemic events in globally leveraged economies serviced by big international banks outside the host country regulatory control.