Collateral Framework: Liquidity Premia and Multiple Equilibria

Category: Macro Seminar
When: 07 November 2023
, 14:15
 - 15:30
Where: HoF E.01/Deutsche Bank
Speaker: Athanasios Orphanides (MIT)

Title: Collateral Framework: Liquidity Premia and Multiple Equilibria

Abstract: Central banks normally accept debt of their own governments as collateral in liquidity operations without reservations. This gives rise to a valuable liquidity premium that reduces the cost of government finance. The ECB is an interesting exception in this respect. It relies on external assessments of the creditworthiness of its member states, such as credit ratings, to determine eligibility and the haircut it imposes on such debt. We show how such features in a central bank’s collateral framework can give rise to cliff effects and multiple equilibria in bond yields and increase the vulnerability of governments to external shocks. This policy can potentially induce sovereign debt crises and defaults that would not otherwise occur. The success of the ECB’s temporary suspension of these features of its collateral framework during the pandemic illustrates the practical relevance of this mechanism. 

Keywords: monetary policy, government finance, yields, liquidity premium, default premium, collateral, cliff effect, multiple equilibria.