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Central bank liquidity provision, risk-taking and economic efficiency

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  • Bindseil, Ulrich
  • Jabłecki, Juliusz
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    Abstract

    After the Lehman default, but also during the euro area sovereign debt crisis, central banks have tended to extend the ability of banks to take recourse to central bank credit operations through changes of the collateral framework (e.g. CGFS, 2008 - in consistence with previous narratives, such as Bagehot, 1873). We provide a simple four sector model of the economy in which we illustrate the relevant trade-offs, derive optimal central bank collateral policies, and show why in a financial crisis, in which liquidity shocks become more erratic and the total costs of defaults increase, central banks may want to allow for greater potential recourse of banks to central bank credit. The model also illustrates that the credit riskiness of counterparties and issuers is endogenous to the central bank's credit policies and related risk control framework. Finally, the model allows identifying the circumstances under which the counterintuitive case arises in which a relaxation of the central bank collateral policy may reduce its expected losses. JEL Classification: E58, G32

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    Bibliographic Info

    Paper provided by European Central Bank in its series Working Paper Series with number 1542.

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    Date of creation: May 2013
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    Handle: RePEc:ecb:ecbwps:20131542

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    Keywords: Central Bank; collateral policy; economic efficiency; Risk-taking;

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    References

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    1. Kavonius, Ilja Kristian & Castrén, Olli, 2009. "Balance Sheet Interlinkages and Macro-Financial Risk Analysis in the Euro Area," Working Paper Series 1124, European Central Bank.
    2. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 401-19, June.
    3. Ewerhart, Christian & Tapking, Jens, 2008. "Repo markets, counterparty risk and the 2007/2008 liquidity crisis," Working Paper Series 0909, European Central Bank.
    4. Holmström, Bengt, 2011. "Inside and Outside Liquidity," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262015783, December.
    5. Charles Goodhart, 1999. "Myths About the Lender of Last Resort," FMG Special Papers sp120, Financial Markets Group.
    6. Xavier Freixas & Curzio Giannini & Glenn Hoggarth & Farouk Soussa, 2000. "Lender of Last Resort: What Have We Learned Since Bagehot?," Journal of Financial Services Research, Springer, vol. 18(1), pages 63-84, October.
    7. James Chapman, Jonathan Chiu, and Miguel Molico, 2010. "Central Bank Haircut Policy," Working Papers 10-23, Bank of Canada.
    8. Douglas W. Diamond, 2001. "Should banks be capitalized?," Economic Quarterly, Federal Reserve Bank of Richmond, issue Fall, pages 71-96.
    9. Douglas W. Diamond & Raghuram G. Rajan, 2001. "Banks and Liquidity," American Economic Review, American Economic Association, vol. 91(2), pages 422-425, May.
    10. Winkler, Adalbert & Bindseil, Ulrich, 2012. "Dual liquidity crises under alternative monetary frameworks," Annual Conference 2012 (Goettingen): New Approaches and Challenges for the Labor Market of the 21st Century 62032, Verein für Socialpolitik / German Economic Association.
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