What determines the supply of good collateral? We study a dynamic model in which borrowers must exert effort to maintain collateral quality and markets become illiquid when average quality is too low. Average quality grows quickly when it is high initially, but deteriorates or grows slowly otherwise. As such, even long-run market conditions are sensitive to a wide array of fundamental and non-fundamental shocks. Recoveries from illiquidity can occur, but only if funding is inefficiently rationed for some time. Policymakers without commitment may fall into intervention traps in which ex-post efficient liquidity injections cause permanent declines in collateral quality.

We model how a cyber attack may be amplified through the U.S. financial system, focusing on the wholesale payments network. We estimate that spillovers of an attack on one of the five most active banks would impair 31% of the network, on average, with some days significantly worse. When other banks respond by liquidity hoarding, forgone payment activity can reach more than 2.5 times daily GDP. A reverse stress test shows attacks on groups of small banks can also impair a significant amount of the network. Interconnectedness through third-party providers and financial market utilities poses additional risks.