Collateral-Enhanced Default Risk

TL;DR

This paper introduces a framework linking collateralization practices to default risk, showing that increased collateralization and remargining frequency can elevate default probabilities, with implications for central counterparty risk management.

Contribution

The paper develops a unified model connecting collateralization dynamics with default risk, incorporating discrete observation effects and providing quantitative insights into collateral triggers and CCP impacts.

Findings

Higher collateralization increases default probability.

Frequent remargining exposes entities to daily volatility.

Central counterparties may raise systemic default risk.

Abstract

Changes in collateralization have been implicated in significant default (or near-default) events during the financial crisis, most notably with AIG. We have developed a framework for quantifying this effect based on moving between Merton-type and Black-Cox-type structural default models. Our framework leads to a single equation that emcompasses the range of possibilities, including collateralization remargining frequency (i.e. discrete observations). We show that increases in collateralization, by exposing entities to daily mark-to-market volatility, enhance default probability. This quantifies the well-known problem with collateral triggers. Furthermore our model can be used to quantify the degree to which central counterparties, whilst removing credit risk transmission, systematically increase default risk.