Risky Financial Collateral, Firm Heterogeneity, and the Impact of Eligibility Requirements

Abstract

This paper studies how Central Bank eligibility requirements affect the supply and quality of bonds issued by non-financial firms. Banks increase demand for eligible bonds, to which firms respond by increasing their debt issuance and, therefore, default risk. We characterize firm responses and aggregate collateral supply in a heterogeneous firm model with endogenous default and eligibility premia. Using a calibration to euro area data, we study the impact collateral easing, consistent with the ECB's policy in the 2008 financial crisis and evaluate the quantitative relevance of firm responses. We find that firm responses substantially deteriorate collateral quality and dampen the total increase in collateral supply to a quantitatively relevant degree. Moreover, our analysis suggests that collateral easing is accompanied by sizeable adverse side effects on the corporate bond market.