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A Theory of Collateral for the Lender of Last Resort
[Imperfect competition in the interbank market for liquidity as a rationale for central banking]

Author

Listed:
  • Dong Beom Choi
  • João A C Santos
  • Tanju Yorulmazer

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.

Suggested Citation

  • Dong Beom Choi & João A C Santos & Tanju Yorulmazer, 2021. "A Theory of Collateral for the Lender of Last Resort [Imperfect competition in the interbank market for liquidity as a rationale for central banking]," Review of Finance, European Finance Association, vol. 25(4), pages 973-996.
    • Handle: RePEc:oup:revfin:v:25:y:2021:i:4:p:973-996.
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    File URL: http://hdl.handle.net/10.1093/rof/rfab002
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    Citations

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    Cited by:

    1. Alves, Nuno & Bonfim, Diana & Soares, Carla, 2021. "Surviving the perfect storm: The role of the lender of last resort☆," Journal of Financial Intermediation, Elsevier, vol. 47(C).
    2. Kaldorf, Matthias & Wicknig, Florian, 2021. "Risky Financial Collateral, Firm Heterogeneity, and the Impact of Eligibility Requirements," VfS Annual Conference 2021 (Virtual Conference): Climate Economics 242413, Verein für Socialpolitik / German Economic Association.
    3. Kris James Mitchener & Eric Monnet, 2023. "Connected Lending of Last Resort," NBER Working Papers 30869, National Bureau of Economic Research, Inc.
    4. Raffaele Lenzi & Stefano Nobili & Filippo Perazzoli & Rosario Romeo, 2023. "Banks’ liquidity transformation rate: determinants and impact on lending," Temi di discussione (Economic working papers) 32, Bank of Italy, Economic Research and International Relations Area.
    5. König, Philipp Johann & Mayer, Paul & Pothier, David, 2022. "Optimal timing of policy interventions in troubled banks," Discussion Papers 10/2022, Deutsche Bundesbank.
    6. Zhao Li & Kebin Ma, 2022. "Contagious Bank Runs and Committed Liquidity Support," Management Science, INFORMS, vol. 68(12), pages 9152-9174, December.
    7. Schmidt, Kirsten, 2019. "Does liquidity regulation impede the liquidity profile of collateral?," Working Paper Series 2256, European Central Bank.

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