Does accepting a broader set of collateral in central bank operations incentivise the use of riskier collateral by riskier counterparties?

Calebe de Roure and Nick McLaren

Central banks accept a wide range of assets from participants as collateral in their liquidity operations – but can this lead to undesired side effects? Such an approach can enhance overall liquidity in the financial sector, by allowing participants to transform illiquid collateral into more liquid assets. But, as a result, the central bank then needs to manage the greater potential risks of holding these riskier assets on its own balance sheet. Financially weaker participants may be encouraged to hold these assets if they can benefit from the higher returns, which compensate for the greater risk. In our recent paper we investigate whether central banks’ acceptance of a broad set of collateral incentivises the concentration of risk by examining the experience of the Bank of England (BoE).

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