Systemic Risk and Monetary Policy: The Haircut Gap Channel of the Lender of Last Resort

Abstract

We show that lender of the last resort (LOLR) policy contributes to higher bank interconnectedness. Using novel micro-level data, we analyze LOLR's haircut-gaps: the differences between the private market and central bank haircuts. LOLR policy incentivizes banks to increase pledging and holdings of higher haircut-gap bonds, especially issued by domestic and systemically important banks. Effects only apply to banks, not to non-banks without LOLR access. LOLR funding revives bank bond issuance associated with higher haircut-gaps and increases subsequent correlation between pledging and issuing banks' bond prices, in particular during periods of low-market returns and for domestic, systemically important banks.

Keywords: Central Bank Liquidity, Haircuts, Collateral, Bank Risk Concentration, Systemic Risk

JEL Classification: E44, E52, E58, F30, G01, G21