Anyone who has a savings account, has taken out a mortgage, or has been part of a business seeking new capital has relied on the smooth functioning of the institutions and markets that collectively perform financial intermediation. Because financial intermediation is so critical to the functioning of a modern economy, it is important to understand its inner workings—its fundamental features, recent innovations, lines of transmission to real economic activity, its imperfections, and its interactions with regulatory policies. As part of an ongoing effort to foster such an understanding, the New York Fed recently hosted the twelfth annual Federal Reserve Bank of New York–New York University Stern School of Business Conference on Financial Intermediation. In this post, we explore some of the discussions and findings from the May 5 conference, which focused on recent advances in the study of financial intermediation.
The Role of Collateral
Collateral facilitates lending in financial markets. Awareness of the functions and features of collateral is thus necessary for understanding how financial markets operate and identifying appropriate policy designs. In the conference’s first presentation, Dong Choi described his theoretical work with coauthors João Santos and Tanju Yorulmazer on the central bank’s optimal lender-of-last-resort (LoLR) policy given the role of collateral in interbank transactions. Though it is crucial for policymakers to understand whether and how to supply financial intermediaries with liquidity in times of market stress, a rigorous theoretical foundation does not yet exist to evaluate LoLR policy and its interactions with the modern financial system. Choi and his coauthors find that under certain conditions, the central bank can actually impair interbank lending when it lends cash against high-quality (as opposed to low-quality) collateral, since this intervention deprives the system of the collateral that is the bedrock of a smoothly functioning interbank market.
But why is collateral so widely used in lending arrangements in the first place? Adam Copeland addressed this question in his presentation. Copeland and his coauthors, Viktoria Baklanova, Cecilia Caglio, and Marco Cipriani, try to distinguish between two possible roles for collateral: as an enforcement mechanism, whereby an entity demands collateral so that counterparties are incentivized to return borrowed cash or securities, or as a screening mechanism, whereby an entity utilizes collateral to tease out low-risk from high-risk counterparties. By analyzing data on the bilateral securities financing market, the authors find evidence that enforcement is not the only purpose of collateral and that collateral is also used for screening at least in some parts of the market.