A theory of collateral for the lender of last resort

Dong Beom Choi, João António Cabral dos Santos, Tanju Yorulmazer

Research output: Contribution to journalArticlepeer-review

1 Citation (Scopus)

Abstract

We consider a macroprudential approach to analyze the optimal lending policy for the central bank, focusing on spillover effects that policy exerts on money 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 with the central bank rather than circulating in markets. Lending against low-quality collateral creates counterparty risk but can improve liquidity in markets. We illustrate the optimal policy incorporating these trade-offs. 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.

Original languageEnglish
Pages (from-to)973-996
Number of pages24
JournalReview Of Finance
Volume25
Issue number4
DOIs
Publication statusPublished - 1 Jul 2021

Keywords

  • Central bank
  • Externality
  • Interbank market
  • Lending facilities
  • Liquidity
  • Macroprudential policy

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