Collateral-Enhanced Default Risk

by Chris Kenyon of Lloyds Banking Group, and
Andrew Green of Lloyds Banking Group

February 19, 2013

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 [encompasses] the range of possibilities, including collateralization re-margining 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.

AMS Classification: 91G20, 91B30, 91B74, 91G40, 91G50, 91B55.

Keywords: Collateral, default, structural default models, triggers, systematic risk, risk transmission, re-margining.

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