The (Unintended?) Consequences of the Largest Liquidity Injection Ever

RePEc Short ID: pfa225
ORCID iD: 0000-0002-3759-2172

Crosignani, Matteo; Faria-e-Castro, Miguel; Fonseca, Luis

doi:10.17016/FEDS.2017.011

Working Paper

The (Unintended?) Consequences of the Largest Liquidity Injection Ever

Abstract: We study the design of lender of last resort interventions and show that the provision of long-term liquidity incentivizes purchases of high-yield short-term securities by banks. Using a unique security-level data set, we find that the European Central Bank?s three-year Long-Term Refinancing Operation incentivized Portuguese banks to purchase short-term domestic government bonds that could be pledged to obtain central bank liquidity. This \"collateral trade\" effect is large, as banks purchased short-term bonds equivalent to 8.4% of amount outstanding. The resumption of public debt issuance is consistent with a strategic reaction of the debt agency to the observed yield curve steepening.

Keywords: Lender of Last Resort; Sovereign Debt; Unconventional Monetary Policy;

JEL Classification: E58; G21; G28; H63;

https://doi.org/10.17016/FEDS.2017.011