The Hidden Collateral Constraint

The collateral constraint of a bank is usually viewed as a “physical” limit to what it can pledge in order to fund its activity, either through the Central bank or private agents. The view here is different. By pledging its best assets for securing its funding, the bank creates an externality: it deprives unsecured lenders and customers’ deposits from the implicit pledge these assets offer. The limit of what can be pledged without weakening the security of these claims is the “hidden collateral constraint”. We build a model of a bank that incorporates this new constraint and show that it may be more powerful than the usual solvency and liquidity constraints. Applied to the euro-zone, it seems already binding. We derive some macroeconomic consequences of our model on credit supply by banks and conclude that it definitely favors a credit crunch, by increasing the spread required by the lender.