Collateral, Financial Arrangements and Pareto Optimality

The existence of collateral requirements to guarantee repayment on issued securities reduces in general the efficiency of competitive equilibria. The general equilibrium analysis is presented in a world where reputation plays no role, and the lender always expects a future payment equal to the future market value of provided collateral. In this context I show that collateral requirements result in two distinct problems for efficiency. I argue that two financial arrangements, tranching and financial pyramiding, arise in developed capital markets in response to the challenges posed by collateral requirements. If these arrangements are sufficiently developed, then the pareto efficiency of competitive equilibria is restored, even in the presence of collateral requirements.