A Theory of Collateral for the Lender of Last Resort

54 Pages Posted: 28 Nov 2016 Last revised: 25 Jan 2019

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

Tanju Yorulmazer

University of Amsterdam - Faculty of Economics and Business (FEB)

Date Written: January 23, 2019

Abstract

We take a macroprudential approach to analyze the optimal lending policy for the central bank, focusing on externalities that policy imposes on private 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 in the central bank rather than circulating in markets. Lending against low-quality collateral creates counterparty risk but can improve liquidity in markets. We characterize the optimal central bank policy incorporating these trade-offs. We show that, 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 23, 2019). 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://WWW.NEWYORKFED.ORG/RMAGHOME/ECONOMIST/SANTOS/CONTACT.HTML

Tanju Yorulmazer

University of Amsterdam - Faculty of Economics and Business (FEB) ( email )

Roetersstraat 11
Amsterdam, 1018 WB
Netherlands

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