A Theory of Collateral for the Lender of Last Resort Dong Beom Choi∗ Federal Reserve Bank of New York 33 Liberty St New York, NY 10045 E-mail:
[email protected] Jo~aoA. C. Santos∗ Federal Reserve Bank of New York & Nova School of Business and Economics 33 Liberty St New York, NY 10045 E-mail:
[email protected] Tanju Yorulmazer∗ University of Amsterdam Plantage Muidergracht 12 Amsterdam, 1018 TV E-mail:
[email protected] March 12, 2017 ∗The views stated herein are those of the authors and are not necessarily the views of the Federal Reserve Bank of New York or the Federal Reserve System. We would like to thank Patrick Bolton, Charles Calomiris, Douglas Gale, Itay Goldstein, Denis Gromb, and Charles Kahn for useful comments. A Theory of Collateral for the Lender of Last Resort We build a model to analyze the optimal lending and collateral policy for the lender of last resort. Key to our theory is the idea that the central bank's policy can impose an externality on private markets. On the one hand, while lending against high-quality collateral protects the central bank from potential losses, it can adversely affect the pool of collateral in funding markets and thus impair their efficient functioning since the much needed high-quality collateral gets tied up with the central bank. On the other hand, while lending against low-quality collateral exposes the central bank to counterparty risk, it improves the pool of collateral in funding markets and can unlock frozen markets. We characterize the optimal policy for a central bank by taking account of these trade-offs.