It makes no sense to include Borrower1's collateral and debt into aggregate values when calculating system risk, as this position is virtually risk-free and would lead to improper calculation of insufficient collateral. Equilibrium sets a cap on portfolio LTV, beyond which the portfolio is considered to be riskless.
So far we've covered risks related to expected and unexpected losses, but we haven't touched on the risks related to excess losses going beyond the stress levels we've set (the right tail in the chart above). In other words, what do we do when the bailsmen themselves get liquidated? Equilibrium uses treasury pool as a third line of defense, where EQ funds that accumulate from interest fees in the treasury are used to cover bailsmen losses.