Collateral eligibility of credit claims and bank liquidity creation: Evidence from China

The central bank's collateral framework plays a fundamental role in implementing quantitative easing and credit easing policies that facilitate liquidity creation. Since the international financial crisis of 2008, it has become a vital tool for central banks in advanced economies to support monetary policy and ensure financial stability. This paper explores how the eligibility of credit claims as collateral influences bank liquidity creation. We develop a theoretical model that considers collateral haircuts, collateral constraints, and bank liquidity creation. Utilizing data on the collateral framework expansion by the People's Bank of China, our findings indicate that recognizing credit claims as eligible collateral can increase bank liquidity creation by 2%. This corresponds to an average boost of 56.4 billion yuan in liquidity for the banks in our sample. Our analysis suggests that this increase is primarily due to enhanced risk tolerance among banks when collateral eligibility is expanded. Additionally, we observe that the effects are most pronounced in large commercial banks and rural commercial banks. To ensure the robustness of our results, we conduct several tests, including parallel trend and placebo tests, which affirm the reliability of our main findings.