Collateralized borrowing and default risk

Abstract

We study how margin requirements in the collateralized borrowing affect banks’ risk exposure. In a model where a firm’s asset value and margin requirement follow correlated geometric Brownian motions, we derive analytic expressions for firm’s default probability and debt value. Our results show that variations in margin requirements, reflecting funding liquidity shocks in the short-term collateralized lending market, can lead to a significant increase in firms’ default risks, in particular for those firms heavily relying on short-term collateralized borrowing. Moreover, our results imply that reducing margin in liquidity crises can be very effective to restore market lending confidence.