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
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: Suggested Citation