Finance
Research insight
November 23, 2021

A Theory of Collateral for the Lender of Last Resort

This can inform and enhance global macroeconomic stability, fostering policy coordination and coherence.

The research paper can be found here.

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.

João Santos

João Santos

João Santos joined Nova School of Business and Economics as a Visiting Professor in September 2011. João Santos currently serves as Senior Vice President of the Federal Reserve Bank of New York.

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