A Theory of Collateral for the Lender of Last Resort*

Imperfect competition in the interbank market for liquidity as a rationale for central banking

Dong Beom Choi, Joao Santos and Tanju Yorulmazer

Review of Finance, 2021, vol. 25, issue 4, 973-996

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.

Keywords: Central bank; Liquidity; Macroprudential policy; Externality; Interbank market; Lending facilities (search for similar items in EconPapers)
Date: 2021
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Citations: View citations in EconPapers (14)

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