A Theory of Collateral for the Lender of Last Resort

Review of Finance, 25(4), 973-996, 2021.

38 Pages Posted: 28 Nov 2016 Last revised: 20 Sep 2023

See all articles by Dong Beom Choi

Dong Beom Choi

Seoul National University - Business School

João A. C. Santos

Federal Reserve Bank of New York; Nova School of Business and Economics

Tanju Yorulmazer

Koc University

Date Written: January 14, 2021

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

JEL Classification: E58, G18, G28

Suggested Citation

Choi, Dong Beom and Santos, João A. C. and Yorulmazer, Tanju, A Theory of Collateral for the Lender of Last Resort (January 14, 2021). Review of Finance, 25(4), 973-996, 2021., Available at SSRN: https://ssrn.com/abstract=2874999 or http://dx.doi.org/10.2139/ssrn.2874999

Dong Beom Choi (Contact Author)

Seoul National University - Business School ( email )

Seoul
Korea, Republic of (South Korea)

João A. C. Santos

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States
212-720-5583 (Phone)
212-720-8363 (Fax)

HOME PAGE: http://HTTP://WWW.NEWYORKFED.ORG/RMAGHOME/ECONOMIST/SANTOS/CONTACT.HTML

Nova School of Business and Economics ( email )

Campus de Carcavelos
Rua da Holanda, 1
Carcavelos, 2775-405
Portugal

Tanju Yorulmazer

Koc University ( email )

Rumeli Feneri Yolu
Sariyer, Istanbul, 34450
Turkey

HOME PAGE: http://gsssh.ku.edu.tr/en/departments/economics/akademik-kadro/show/tyorulmazer/

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