Collateral composition, diversification risk, and systemically important merchant banks

• Borrowers demand assets unrelated to their own activity as a buffer against losses.
• The financial system both provides this buffer and holds claims on non-financials.
• Under systemic events, the collateral diversification turns into a domino collapse.
• Government guarantees of the financial system liabilities are costly.
• As risk-absorbers, CoCos on bank balance are preferable to the official guarantees.

The impact of collateral diversification by non-financial firms on systemic risk is studied in a general equilibrium model with standard production functions and mixed debt-equity financing. Systemic risk comes about as soon as firms diversify their collateral by holding claims on a big wholesale (merchant) bank whose asset side includes claims on the same producer set. The merchant bank sector proves to be fragile (has a short distance to default) regardless of competition. In this setting, the policy response, consisting in official guarantees for the merchant bank's liabilities, entails considerable government loss risk. An alternative without the need for public sector involvement is to encourage systemically important merchant banks to introduce a simple bail-in mechanism by restricting their liabilities to contingent convertible bonds. This line of regulatory policy is particularly relevant to the containment of systemic events in globally leveraged economies serviced by big international banks outside host country regulatory control.