Staff Working Paper No. 987
By Chuan Du
In periods of stress, acute liquidity squeeze can manifest in the riskier segments of the credit market, even amid a surplus of aggregate liquidity. In such scenarios, central bank interventions that directly lower the risky interest rate can be more effective than reductions in the risk-free interest rate. Specifically, the central bank lends to the market at more favourable interest rates while simultaneously reducing the haircuts imposed on eligible collateral. In doing so, the central bank takes on greater credit risk, but achieves an outcome that is more productively efficient than simply reducing the risk-free interest rate.
Collateral requirements in central bank lending 