Collateral, Central Bank Repos, and Systemic Arbitrage

Abstract

Central banks are under increased scrutiny because of the rapid growth in, and composition of, their balance sheets. Therefore, understanding the processes that shape these balance sheets and their consequences is crucial. We contribute by studying an extensive dataset of banks’ liquidity uptake and pledged collateral in central bank repos. We document systemic arbitrage whereby banks funnel credit risk and low-quality collateral to the central bank. Weaker banks use lower quality collateral to demand disproportionately larger amounts of central bank money (liquidity). This holds both before and after the financial crisis and may contribute to financial fragility and fragmentation.

Keywords: Collateral, repo, systemic arbitrage, central bank, collateral policy, banks, liquidity, interbank market, financial stability, financial fragmentation

JEL Classification: G12, G21, E42, E51, E52, E58