International and domestic collateral constraints in a model of emerging market crises

• Published in: Journal of monetary economics 2001-12, Vol.48 (3), p.513-548
• Main Authors: Caballero, Ricardo J., Krishnamurthy, Arvind
• Format: Article
• Language: English
• Subjects: Balance sheets; Banks; Borrowing; Capital flow; Capital flows; Capital movement; Collateral; Collateral under provision; Contractual and corporate governance problems; Domestic and foreign spreads; Economic crisis; Economic models; Emerging markets; Excessive leverage; Finance; Fire sales; Interest rates; Macroeconomics; Microeconomic and aggregate financial constraints; Microeconomics; Monetary economics; Real depreciation; Studies; Wasted collateral
• ISSN: 0304-3932; 1873-1295
• DOI: 10.1016/S0304-3932(01)00084-8

We build a model of emerging markets crises which features two types of collateral constraints. Firms in a domestic economy have limited borrowing capacity from international investors. They also have limited borrowing capacity with respect to each other. We study how the presence and changes in these collateral constraints affect financial and real variables. A binding international constraint in the aggregate leads to a sharp rise in interest rates and fire sales of domestic assets, while limited domestic collateral can lead to wasted international collateral. These two collateral constraints can interact in important ways. The first is disintermediation: a fire sale of domestic assets causes banks to fail in their function of reallocating resources across the economy leading to wasted international collateral. The second is a dynamic effect. We show that firms in an economy with limited domestic collateral and a binding international collateral constraint will not adequately precaution against adverse shocks, increasing the severity of these shocks.