Regulating collateral-requirements when markets are incomplete

In this paper we examine the effects of default and scarcity of collateralizable durable goods on risk-sharing. We assume that there is a large set of assets which all promise a risk-less payoff but which distinguish themselves by the collateral requirement. In equilibrium agents default and the assets have different payoffs. Assets with very low collateral requirements can be interpreted as sub-prime loans and these assets are often traded actively in the competitive equilibrium. If there is an abundance of commodities that can be used as collateral and if each agent owns a large fraction of these commodities, markets are complete and competitive equilibrium allocations Pareto optimal. If, on the other hand, the collateralizable durable good is scarce or if some agents do not own enough of the collateralizable durable good in the first period, markets can be endogenously incomplete, not all of the available assets are traded in the competitive equilibrium and allocations are not Pareto optimal. We give examples that show that welfare losses can be quantitatively large. We also examine the scope for government intervention. In particular we ask who in the economy gains and who loses if collateral requirements are regulated exogenously. In our examples, regulation never leads to a Pareto-improvement. Often, the rich and the poor agents gain if trade is restricted to subprime contracts and lose if trade is these contracts is not allowed.