DP16240 Systemic Risk and Monetary Policy: The Haircut Gap Channel of the Lender of Last Resort
We show that lender of the last resort (LOLR) policy contributes to higher bank interconnectedness and associated systemic risk. Using novel micro-level data, we analyze the haircut gap channel of LOLR--the difference between the private market and central bank haircuts. LOLR increases interconnectedness by incentivizing banks to pledge higher haircut gap bonds, especially issued by similar banks and by systemically important banks. LOLR also exacerbates cross-pledging of bank bonds. Higher haircut gaps only incentivize banks, not other intermediaries
without LOLR access, to increase bank bond holdings. Finally, LOLR revives bank bond issuance associated with higher haircut gaps.