Collateralizing liquidity

Abstract

I develop a dynamic model of optimal funding to understand why financial assets are used as collateral instead of being sold to raise funds. Firms need funds to invest in risky projects with nonobservable returns. Since holding these assets allows firms to raise these funds, investing firms value the asset more than noninvesting ones. When assets are less than perfectly liquid and investment opportunities are persistent, collateralized debt minimizes asset transfers from investing to noninvesting firms and thus is optimal. Frictions in asset markets lead to an illiquidity discount and a collateral premium, which increase with the asset’s illiquidity.