The collateral composition channel

Wholesale financial markets reallocate deposits. Because of incentive problems, these flows are limited by endogenous collateral constraints. The composition of collateral matters. The use of inside collateral creates a "collateral pyramid": cash flows from one loan are pledged to secure another. Outside collateral, such as treasuries, stabilizes the pyramid. Through collateral pyramids the financial sector sustains a large volume of reallocation across banks, but at the cost of systemic panics. During panics, the safe asset creation process stalls, the pyramid collapses, collateral becomes scarce. Markets are more fragile when loans are secured by inside collateral.