A Theory of Collateral for the Lender of Last Resort. (5th February 2021)

• Record Type: Journal Article
• Authors: Choi, Dong Beom; Santos, João A C; Yorulmazer, Tanju
• Is Part Of: Review of finance. Volume 25:Number 4(2021)
• Page Start: 973
• Page End: 996
• Publication Date: 2021-02-05
• Subjects: Central bank -- Liquidity -- Macroprudential policy -- Externality -- Interbank market -- Lending facilities; Finance -- Europe -- Periodicals; Financiën; Finance; Periodicals; 332.09405
• DOI: 10.1093/rof/rfab002
• Languages: English
• ISSNs: 1572-3097

Abstract

Abstract: We consider a macroprudential approach to analyze the optimal lending policy for the central bank, focusing on spillover effects that policy exerts on money markets. Lending against high-quality collateral protects central banks against losses, but can adversely affect liquidity creation in markets since high-quality collateral gets locked up with the central bank rather than circulating in markets. Lending against low-quality collateral creates counterparty risk but can improve liquidity in markets. We illustrate the optimal policy incorporating these trade-offs. Contrary to what is generally accepted, lending against high-quality collateral can have negative effects, whereas it may be optimal to lend against low-quality collateral.