Money markets, collateral and monetary policy

February 2022 (revised March 2024)

Summary

Focus

Our paper focuses on the money market developments observed in the euro area during the financial and sovereign debt crises. We emphasize four main facts. First, the share of unsecured interbank borrowing declined throughout the euro area, with banks substituting towards secured transactions. Second, with the onset of the sovereign debt crisis, market haircuts on southern government bonds increased substantially, while the European Central Bank (ECB) kept haircuts nearly unchanged throughout. Third, bank borrowing from the ECB increased eight-fold in southern regions. Fourth, household deposits at banks remained stable.

Contribution

We construct a quantitative general equilibrium model to understand these developments, the policies employed by the ECB and their impact on the overall economy. The model features heterogeneous banks and heterogeneous government bonds, interbank money markets for both secured and unsecured credit, and a central bank that can conduct open market operations and lend to banks against collateral. Our analysis emphasizes the leverage, liquidity and collateral constraints of banks. We use the model to clarify the role of different interbank market frictions and to quantify the impact of central bank responses. We do so by comparing a counterfactual scenario of no central bank intervention with a benchmark policy that provides collateralized lending to banks at haircuts lower than available in the private market.

Findings

We demonstrate that the two policies do not differ much in terms of their impact on the economy when the share of secured lending changes, but they induce significantly different responses when private market haircuts rise. In particular, the fall in output, investment and capital would have been twice as high under the constant-balance sheet policy compared with the benchmark.

Abstract

During the financial and sovereign debt crises, euro area interbank money markets underwent dramatic changes: the share of unsecured borrowing declined throughout the euro area, while private market haircuts on sovereign bonds and bank borrowing from the European Central Bank increased in the South. We construct a quantitative general equilibrium model to evaluate the macroeconomic impact of these developments and the associated policy response. Our model features heterogeneous banks and sovereign bonds, secured and unsecured money markets, and a central bank. We compare a benchmark policy – the central bank providing collateralized lending to banks at haircuts lower than the market - to an alternative policy that maintains a constant central bank balance sheet. We show that the fall in output, investment, and capital would have been twice as high under the alternative policy. More generally, the model allows the analysis of monetary policy tools beyond interest rate policies and quantitative easing.

JEL classification: E44, E52, E58

Keywords: money markets, collateral, monetary policy, balance sheet policies