Collateral Requirements: Macroeconomic Fluctuations and Macro-Prudential Policy

What are the macroeconomic implications of higher leveraged borrowing? To address this question, we develop a business cycle model with credit frictions in which firms reallocate capital among themselves through the credit market. We find that looser collateral requirements moderate the sensitivity of investment and output to changes in productivity but sharpen the response to shocks originated in the credit market. This result poses a challenge to the design of a macro-prudential policy framework that aims to mitigate pro-cyclicality in the financial market and improve macroeconomic stability. We document that, contrary to discretionary lower caps on loan-to-value ratios, time-varying caps that counter-cyclically respond to indicators of financial imbalances are successful in smoothing credit-cycles without increasing the sensitivity of the economy to real shocks. Further, countercyclical loan-to-value ratios also dampen macroeconomic volatility without reducing the size of the economy.