The (Unintended?) Consequences of the Largest Liquidity Injection Ever

We analyze some of the potentially unintended consequences of the largest liquidity injection ever conducted by a central bank: the European Central Bank’s three-year Long-Term Refinancing Operations conducted in December 2011 and February 2012. Using an unique dataset on monthly security- and bank-level holdings of government bonds for Portugal, we analyze the impact of this unconventional monetary policy operation on the demand for government debt. We find that: (i) Portuguese banks significantly increased their holdings of domestic government bonds after the announcement of this policy; (ii) This increase in holdings was tilted towards shorter maturities, with banks rebalancing their sovereign debt portfolios towards shorter term bonds. We employ a theoretical framework to argue that domestic banks engaged in a “collateral trade†, which involved the purchase of high yield bonds with maturities shorter than the central bank borrowing in order to mitigate funding liquidity risk. Our model delivers general equilibrium implications that are consistent with the data: the yield curve for the Portuguese sovereign steepens after the announcement, and the timing and characteristics of government bond auctions are consistent with a strategic response by the debt management agency.