The Role of Collateral Frameworks in Monetary Policy

Collateral frameworks are an often overlooked part of monetary policy, yet they play a crucial role in the monetary and financial system. These frameworks are used to guarantee the stability of financial markets. In turn, central banks can provide credit to savers and businesses. However, they are often the subject of controversy.

Collateral frameworks have various benefits, but they can also hinder market discipline and the incentives of banks to monitor their debtors. Moreover, they can exacerbate political influence over banks by extending favorably to collateral backed by government guarantees. In addition, collateral frameworks can weaken the central bank’s balance sheet by facilitating indirect bailouts.

Green collateral frameworks can help reduce environmental risks, as they take into account the environmental footprint of assets. Using the “eco-footprint” approach can also help central banks fight the environmental crisis by reducing systemic risks. Unlike the “environmental risk exposure” approach, this approach is unlikely to penalise companies that are exposed to environmental risks. Green collateral frameworks can also contribute to the decarbonisation of the financial system by fostering environmental-friendly practices in financial markets.

The collateral framework should be sufficiently large to cover the periods of liquidity pressure, and counterparties should ensure that the collateral supply always exceeds liquidity needs. In addition, collateral frameworks should be formulated in a way that specifies the scope and duration of the plan. They should also avoid ex ante time limits. The central bank should be willing to adjust their criteria after the crisis, as new structural changes, regulation, and technology may affect the demand for liquidity.

The European collateral framework, however, is far from ideal. As an example, the structure of the domestic money and fixed-income markets has made it difficult to determine the market value of domestic government securities. Moreover, more than 30,000 different securities are eligible for collateral. A major issue with these securities is that the vast majority of them lack market prices, and one-third of them trades on non-regulated markets.

In modern monetary systems, central banks use collateral frameworks to inject money into the economy on terms determined by their policies. This can be distortive, as it impairs the role of market forces and discipline. The paper highlights the importance of government guarantees and ratings as collateral frameworks. The authors also discuss the role of central bank collateral frameworks in the euro area.

The availability of collateral is a crucial constraint on central bank credit. It is a critical part of monetary policy and financial stability. The ECB collateral framework is a good example of this. It explains how collateral eligibility should be determined, and how risk control measures should be implemented. These frameworks must be quantitatively defined to ensure credibility, and the criteria should be calibrated. Ideally, they should achieve neutrality among asset classes. The latter would minimise the possibility of market distortions.

The ECB can exercise significant control over collateral values in a country through the collateral framework. For example, it can make margin calls, increase haircuts, or reject certain sovereign bonds as collateral. In this way, the ECB indirectly bailed out some sovereigns and banks in the Eurozone.

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