Credit Risk and Discontinuous Effects of Monetary Reverse Transactions

Abstract

A central bank possesses various instruments to provide liquidity. These are either outright monetary transactions (OMT) of securities or other refinancing facilities, primarily repos, which are executed with standard tenders. The eligible securities (i.e. bonds or equities) need to conform with certain credit risk criteria (i.e., satisfactory credit rating or low default probability). This paper introduces a monetary model to address the role of collateralized securities on the effectiveness of monetary policy. Our results suggest that credit rating downgrading may precipitate into a disproportionate credit contraction.

Keywords: collateralized securities; central banks; endogenous tender rate

JEL Classification: D53, E41, E51, E52, E58