A Theory of Collateral for the Lender of Last Resort

We take a macroprudential approach to analyze the optimal lending policy for the central bank, focusing on externalities that policy imposes on private 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 in the central bank rather than circulating in markets. Lending against low-quality collateral creates counterparty risk but can improve liquidity in markets. We characterize the optimal central bank policy incorporating these trade-offs. We show that, 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