Money markets, collateral and monetary policy

BIS Working Papers  |  No 997  | 
01 February 2022



Interbank money markets are essential for banks' liquidity management. They are also important for monetary policy implementation as central banks often target interbank rates. Our paper focuses on two major and persistent money market developments that have occurred in the euro area over the past 15 years: the falling importance of the unsecured interbank market relative to the secured market and, relatedly, the rising exposure of banks to the risk of increases in collateral haircuts. We ask how these developments have affected bank lending, real activity and the conduct of monetary policy.


Our novel general equilibrium model features different kinds of banks, interbank markets for both secured and unsecured credit, and a central bank. The interaction between occasionally binding constraints, particularly on leverage and liquidity, are key in determining macroeconomic outcomes. We consider three different monetary policies: a pre-Great Financial Crisis policy characterised by a constant balance sheet, a policy of balance sheet expansion via collateralised credit operations, and a policy of outright asset purchases. We calibrate the model to euro area data so that we can study how the observed money market developments evolve under the different monetary policies.


We find that frictions in the secured and unsecured money markets force banks to either divert resources into unproductive but liquid assets or to reduce leverage, thus reducing lending and economic output. When the share of banks with access to unsecured lending shrinks, the constant-balance sheet or collateralised credit operations policies act similarly, as there is no advantage in borrowing from the central bank as long as the private secured market functions smoothly. By contrast, outright asset purchases inject liquidity and alleviate liquidity constraints, which reduces the negative effects on output. If haircuts increase in the private markets, the key to mitigating the output drop is for the central bank to expand its balance sheet, thus easing the liquidity constraints. This can be achieved both via lending to banks against collateral with favourable haircuts, or via central bank purchases of government bonds.


Interbank money markets have been subject to substantial impairments in the recent decade, such as a decline in unsecured lending and substantial increases in haircuts on posted collateral. This paper seeks to understand the implications of these developments for the broader economy and monetary policy. To that end, we develop a novel general equilibrium model featuring heterogeneous banks, interbank markets for both secured and unsecured credit, and a central bank. The model features a number of occasionally binding constraints. The interactions between these constraints - in particular leverage and liquidity constraints - are key in determining macroeconomic outcomes. We find that both secured and unsecured money market frictions force banks to either divert resources into unproductive but liquid assets or to de-lever, which leads to less lending and output. If the liquidity constraint is very tight, the leverage constraint may turn slack. In this case, there are large declines in lending and output. We show how central bank policies which increase the size of the central bank balance sheet can attenuate this decline.

JEL classification: E44, E52, E58.

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