In the wake of the financial crisis, there have been numerous proposals for “fixing” the financial system. Many of these place increased demand on collateral. It is therefore important to realize the limitations of collateral as a problem-solving tool. In this chapter, I draw on the insights and findings from previous chapters to discuss some of the more obvious problems with systems that place large demand on collateral. In this context, I discuss two high-profile topics, namely the interbank market for liquidity and the resurrection of the 1930s-era “Chicago Plan” of full reserve banking.

THE FUNDAMENTAL PROBLEM

The fundamental problem with collateral is that there is a limited amount of it that can be considered “good.” Financial systems that place large demands on collateral may face a shortage of high-quality collateral. Furthermore, as demand for collateral increases, more of it will have to be rated, or assessed in some way, and monitored. This is expensive. The ratings process is also fraught with problems, as touched on in Chapter 6. The lower down the quality scale one must go, the larger are the problems associated with the ratings process likely to be.

Collateral serves a valuable purpose because it reduces concerns about default and may therefore increase the willingness of counterparties to trade. This effect is a function of the liquidity of the underlying collateral. Securities that cannot be traded in the market, except at heavy discounts relative to fundamentals, are not suitable as collateral. The point with collateral is that losses can be covered in case of counterparty default. It is therefore important to note that there is not an active market for most securities.

As discussed in Chapter 7, conservatively estimated based on information in the Bloomberg system, only about 20 percent of the securities that are on the Eurosystem's public list of eligible collateral are sufficiently actively traded that they have fresh market prices, or quotes, on a daily basis. Furthermore, even if a security has a daily updated market price, it does not mean that arbitrarily large quantities can be traded at that price. It is well documented in the market microstructure literature that limited depth is ubiquitous in financial markets.