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Federal Reserve Bank of St. Louis
Working Papers
The (Unintended?) Consequences of the Largest Liquidity Injection Ever
Matteo Crosignani
Miguel Faria-e-Castro
Luis Fonseca
Abstract

The design of lender-of-last-resort interventions can exacerbate the bank-sovereign nexus. During sovereign crises, central bank provision of long-term liquidity incentivizes banks to purchase high yield eligible collateral securities matching the maturity of the central bank loans. Using unique security level data, we find that the European Central Bank’s 3-year Long-Term Refinancing Operation caused Portuguese banks to purchase short-term domestic government bonds, equivalent to 10.6% of amounts outstanding, and pledge them to obtain central bank liquidity. The steepening of Eurozone peripheral sovereign yield curves right after the policy announcement is consistent with the equilibrium effects of this “collateral trade.”


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Matteo Crosignani & Miguel Faria-e-Castro & Luis Fonseca, The (Unintended?) Consequences of the Largest Liquidity Injection Ever, Federal Reserve Bank of St. Louis, Working Papers 2017-39, 01 Nov 2017, revised 30 Jan 2019.
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Keywords: Lender of Last Resort; Bank-Sovereign Nexus; Collateral; Sovereign Debt; Eurozone Crisis
DOI: 10.20955/wp.2017.039
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