The (Unintended?) Consequences of the Largest Liquidity Injection Ever

We study the design of lender of last resort interventions and show that the provision of long-term liquidity incentivizes purchases of high-yield short-term securities by banks. Using a unique security-level data set, we find that the European Central Bank’s three-year Long-Term Refinancing Operation incentivized Portuguese banks to purchase short-term domestic government bonds that could be pledged to obtain central bank liquidity. This “collateral trade” effect is large, as banks purchased short-term bonds equivalent to 8.4% of amount outstanding. The resumption of public debt issuance is consistent with a strategic reaction of the debt agency to the observed yield curve steepening.

Keywords: Lender of Last Resort, Unconventional Monetary Policy, Sovereign Debt

JEL Classification: E58, G21, G28, H63

Suggested Citation: Suggested Citation

Crosignani, Matteo and Faria-e-Castro, Miguel and Fonseca, Luís, The (Unintended?) Consequences of the Largest Liquidity Injection Ever (December, 2016). ESRB: Working Paper Series No. 2016/31, Available at SSRN: https://ssrn.com/abstract=3723377 or http://dx.doi.org/10.2139/ssrn.3723377