A Theory of Collateral for the Lender of Last Resort
54 Pages Posted: 28 Nov 2016 Last revised: 25 Jan 2019
Date Written: January 23, 2019
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: Suggested Citation