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Chapman, James
Chiu, Jonathan
Molico, Miguel
Year of Publication: 
Series/Report no.: 
Bank of Canada Working Paper 2010,23
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 an unexpected drop in the haircut, the central bank can be more aggressive than when setting a permanent level of the haircut.
clearing and settlement systems
Central bank research
Monetary policy implementation
Financial system regulation and policies
Financial services
Document Type: 
Working Paper

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