DP11663 Collateral, Central Bank Repos, and Systemic Arbitrage

Author(s): Falko Fecht, Kjell G Nyborg, Jörg Rocholl, Jiri Woschitz
Publication Date: November 2016
Keyword(s): banks, central bank, Collateral, collateral policy, financial fragmentation, financial stability, interbank market, liquidity, repo, systemic arbitrage
JEL(s): E42, E51, E52, E58, G12, G21
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=11663

Central banks are under increased scrutiny because of the rapid growth in, and composition of, their balance sheets. Therefore, understanding the processes that shape these balance sheets and their consequences is crucial. We contribute by studying an extensive dataset of banks' liquidity uptake and pledged collateral in central bank repos. We document systemic arbitrage whereby banks funnel credit risk and low-quality collateral to the central bank. Weaker banks use lower quality collateral to demand disproportionately larger amounts of central bank money (liquidity). This holds both before and after the financial crisis and may contribute to financial fragility and fragmentation.