Financial innovation, collateral hedging and Macro-prudential policies

Thispaperfeaturesaneconomywithincompletemarkets,collateralisedlendingandinvestorsthat hold heterogeneous beliefs about the states of the world. Financial innovation takes the form of collateral hedging, which enables collateral protection insurance (CPI) contracts together with existing investmentincapitaltobackloans. Thecontributionofthispaperistocharacterizetheeffectiveness of two macro-prudential policies, namely higher collateral requirements on CPI or capital, towards mitigating default friction and maximizing social welfare. The degree of belief disagreement is an important factor determining the effectiveness of policy. When disagreement is extreme, then the policy via financial innovation is not effective, unless it is not costly, and macro-prudential interventions call for higher collateral requirements on capital; while under moderate levels of disagreement, increasingcollateralrequirementsoncapitalisnoteffective, andpolicyinterventionscallforfinancial innovation.