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Title: Collateral Framework: Liquidity Premia and Multiple Equilibria

Author(s): Yvan Lengwiler and Athanasios Orphanides

Publication Date: April 2021

Keyword(s): cliff effect, Collateral, Default premium, government finance, liquidity premium, monetary policy, multiple equilibria and yields

Programme Area(s): Monetary Economics and Fluctuations

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 can potentially induce sovereign debt crises and defaults that would not otherwise arise.

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Bibliographic Reference

Lengwiler, Y and Orphanides, A. 2021. 'Collateral Framework: Liquidity Premia and Multiple Equilibria'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=16047