The relative price(s) of money and collateral matter for financial lubrication in the markets. Some central banks are now a major player in the collateral markets. Analogous to a coiled spring, the larger the quantitative easing efforts, the longer the central banks will impact the collateral market and associated repo rate. This may have monetary policy and financial-stability implications since the repo rates maps the financial landscape that straddles the bank/non-bank nexus.

Introduction

The importance of collateral has been investigated in several strands in the theoretical literature. One strand is the literature on collateral and default, which has focused primarily on the role of margin and “haircuts” and “fire sales” (Geanakoplos 2003; Krishnamurthy, Nagel, and Orlov 2010). Another strand is on securitization, where collateral serves to support specific asset values (Shleifer and Vishny 2011).

This chapter echoes discussions on the supply and demand of safe assets. Empirical evidence that the (demand for) safe-asset share has been relatively stable was postulated by Gorton et al. (2012) using flow-of-funds data only. Concerns have been raised about the supply of safe assets. The IMF's Global Financial Stability Report estimated a US$74 trillion figure for safe assets (April 2012), which would appear to be ample. However, a large fraction of such safe assets is held by buy-and-hold investors and is not available for reuse in financial markets. Some market sources conclude that there is little evidence to support that good collateral will be in short supply (J. P. Morgan). Others argue that there could be such a shortage and that safe assets should be provided as a public good to avoid financial instability associated with the private supply of safe assets. This thinking is now being reflected in the US Federal Reserve's recent reverse repo program.

This contribution has three aims. It first clarifies the distinction between the price of money and the price of collateral. It then discusses the factors driving the demand and supply of collateral. Finally, it highlights the importance of collateral for monetary policy through an updated IS/LM framework. With this, the contribution reflects on the prospects for unwinding extraordinary monetary policy interventions.