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Central bank haircut policy

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Abstract

We present a model of central bank collateralized lending to study the optimal choice of the haircut policy. We show that a lending facility provides a bundle of two types of insurance: insurance against liquidity risk as well as insurance against downside risk of the collateral. Setting a haircut therefore involves balancing the trade-off between relaxing the liquidity constraints of agents on one hand, and increasing potential inflation risk and distorting the portfolio choices of agents on the other. We argue that the optimal haircut is higher when the central bank is unable to lend exclusively to agents who actually need liquidity. Finally, for a temporary surprise drop in the haircut, the central bank can be more aggressive than when setting a permanent level of the haircut.

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Authors and Affiliations

  1. Bank of Canada, 234 Wellington Street, Ottawa, ON, K1N 7L7, Canada

    James T. E. Chapman, Jonathan Chiu & Miguel Molico

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  1. James T. E. Chapman
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  2. Jonathan Chiu
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  3. Miguel Molico
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Correspondence to James T. E. Chapman.

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Chapman, J.T.E., Chiu, J. & Molico, M. Central bank haircut policy. Ann Finance 7, 319–348 (2011). https://doi.org/10.1007/s10436-010-0171-5

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  • DOI: https://doi.org/10.1007/s10436-010-0171-5

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