Haircuts, interest rates, and credit cycles

In the presence of lenders' wrong perception of collateral quality, haircuts help to reduce the excessive financing costs due to the gap between lenders' perceived and actual risk. We study the credit cycles driven by the dynamic interaction between the terms of the collateralized loan contracts and lenders' beliefs. Risky loans are more sensitive to collateral quality information than safe loans because defaults reveal the information about collateral quality. Endogenously determined information revelation can explain the increases in haircuts during the recent financial crisis and the positive relationship between the long quiet period and the impact of the crisis. The asymmetry between boom and bust dynamics can explain the difference in the opacity of collateralized loan contracts, the asymmetric impacts of revealed good and bad news, and can help to predict financial crises. A macroprudential policy of setting a minimum haircut can reduce output fluctuation, and a policy combining a minimum haircut and a collateral insurance can both stabilize the economy and further improve social welfare.