A new ECB paper illustrates the power of a central bank’s collateral framework as a policy tool. The collateral framework influences overall monetary conditions, helps preserving financial stability, and functions even at the zero lower bound for policy rates. Liquidity regulation can be an important complement, since by themselves generous collateral buffers might invite moral hazard and encourage excessive reliance on short-term funding.

“Central bank collateral, asset fire sales, regulation and liquidity”, Ulrich Bindseil
ECB Working Paper Series, no. 1610, November 2013

http://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1610.pdf

The below are excerpts from the paper. Cursive lines and emphasis has been added.

Collateral framework and liquidity regulation: The basics

“The central bank collateral framework…is one of the most complex and economically significant elements of monetary policy implementation. Unencumbered central bank eligible collateral is potential liquidity, as it can, in principle, be swapped into central bank money…Changes to the collateral framework also seem to play a role as monetary policy instrument (i.e. beyond being an instrument to address a liquidity crisis) when central banks approach the zero lower interest rate bound. For example, the Bank of England’s “Funding for lending” scheme also relies on a widening of the collateral framework.”

“In the case of the Eurosystem, out of EUR 32 trillion of aggregated bank assets, the value of central bank eligible collateral after haircuts that could be used at any moment in time is around EUR 5 trillion [15.6%]. The eligibility criteria and haircut matrices are provided by the ECB.”

“In January 2013, the Basle Committee on Banking Supervision has issued again, after a number of adaptations, a document describing Basle III liquidity regulation, and in particular the so-called Liquidity Coverage Ratio (LCR) and the related concept of High Quality Liquid Assets (HQLA). The Financial crisis of 2007/2008 is said to also have been triggered by the insufficient asset liquidity buffers of banks relative to their short term liabilities. These insufficient buffers would have led to an (at least temporarily) excessive reliance on central bank funding…The LCR requires a certain amount of HQLAs to be maintained by banks relative to possible liquidity outflows in a one month stress scenario. The Basel Committee considers as constituting characteristic of HQLAs that they can be fire-sold without large losses even under stressed circumstances.”

A model analysis

“This paper provides a simple model of the interaction between the asset liquidity of banks, the central bank collateral framework, and liquidity regulation, such as to better understand the effects of these factors on financial stability and the ability of the banking system to deliver maturity transformation, which is one of its key functions for society.”

Stability of short term bank funding is modeled as strategic game of short term depositors who have the option to keep their deposits with the bank or to ‘run’…The effects of the key exogenous variables (asset liquidity, central bank collateral framework, regulation) on the endogenous variables are derived, namely on (i) …the mix of short term funding, long term funding, and equity, (ii) the relative reliance on…fire sales versus central bank credit, and on (iii) the funding costs of banks.”

Main propositions

“Changes of the collateral framework can be understood as a policy tool to maintain financial stability, explaining why most central banks tended to extend collateral eligibility in 2007 and 2008…The challenge for the central bank is to use the tool to extend collateral buffers ex post in a liquidity crisis, without inviting banks to factor this in ex ante…In a crisis characterized by a drop in asset liquidity, a widening of central bank collateral buffers can contribute to preserve market access of banks and hence to prevent large recourse to the central bank.”

“The identified impact of asset liquidity and of the central bank collateral framework on funding costs of banks is relevant for monetary policy for at least two reasons. First, policy makers need to be aware that a tightening of any of the two emergency liquidity sources also tightens, everything else unchanged, monetary conditions. Second, when the central bank has reached the zero lower bound…it could consider to use its collateral framework to ease monetary conditions… The use of the collateral framework for policy purposes (financial stability and monetary policy) has of course to take place with due consideration to the original purpose of the collateral framework, which is the protection of the central bank.”

“Absent regulation, the tighter the central bank collateral framework, the higher the equilibrium shares of bank equity and long term funding in the total length of bank balance sheets, and the higher the average funding costs of banks, which is a proxy for the lower ability of the banking system to deliver maturity transformation.”

Liquidity regulation improves social welfare by imposing excess liquidity buffers in normal times beyond those that banks would hold voluntarily, such that sudden declines of asset liquidity trigger with less probability a destabilization of short term liabilities and the associated negative externalities.”