Breaking Bagehot's Rules: Loan Contracting with Advantageous Central Bank Funding

68 Pages Posted: 14 Dec 2022 Last revised: 23 Jan 2024

See all articles by Christian Eufinger

Christian Eufinger

IESE Business School

Zhiqiang Ye

University of Navarra, IESE Business School

Date Written: January 26, 2024

Abstract

We demonstrate that central bank funding schemes with favorable interest rates or advantageous collateral terms can adversely influence bank loan contracting and borrower investment efficiency. Such schemes result in loan contracts that encourage borrowers to leverage excessively and overinvest. Additionally, schemes with lenient collateral requirements lead banks to steer borrowers towards high-risk, inefficient investments. The interactions between such schemes' preferential features and the interest rate environment prove complex: both enhancing the attractiveness of their funding rate and a market rate decline can intensify the adverse effects of their preferential collateral terms on loan agreements and the efficiency of borrower investments.

Keywords: Preferential Central Bank Funding, Monitoring, Risk-Shifting, Real Effects, Overinvestment, Leverage

JEL Classification: E58, G20, G21, G28

Suggested Citation

Eufinger, Christian and Ye, Zhiqiang, Breaking Bagehot's Rules: Loan Contracting with Advantageous Central Bank Funding (January 26, 2024). Available at SSRN: https://ssrn.com/abstract=4286891 or http://dx.doi.org/10.2139/ssrn.4286891

Christian Eufinger (Contact Author)

IESE Business School ( email )

Avinguda de Pearson, 21
Barcelona, 08034
Spain

Zhiqiang Ye

University of Navarra, IESE Business School ( email )

Avenida Pearson 21
Barcelona, 08034
Spain

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