Breaking Bagehot's Rules: Loan Contracting with Advantageous Central Bank Funding
68 Pages Posted: 14 Dec 2022 Last revised: 23 Jan 2024
Date Written: January 26, 2024
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: Suggested Citation