Review of Finance Vol. 25 No. 4 2021
A Theory of Collateral for the Lender of Last Resort
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.
- DOI
- 10.1093/rof/rfab002
- Volume
- 25
- Issue
- 4
- Pages
- 973-996
- Language
- en
- Sources
- bibtex:phds-export.bib openalex crossref