International Banker: Collateral is central bank policy’s secret sauce

Modern economies run on the back of a monetary and financial system through which most transactions ultimately settle in central bank money. As the ultimate issuers of money, central banks are imbued with substantial power to influence financial markets and the real economy. It is important to understand how they use this power and the associated implications. While public attention and most academic work focuses on interest-rate policy, central banks also set policy in another sphere of influence that is more closely linked to the money-creation process, namely with respect to the collateral against which they issue money.

It is a little appreciated or discussed fact that central bank money is issued against collateral — paper assets such as government bonds, bank bonds, and non-marketable credit claims. The details regarding the type of collateral that central banks accept and the terms of exchange between collateral and money are tucked away in policy documents with the technocratic sounding label: collateral framework. These frameworks constitute a largely ignored, almost hidden, aspect of monetary policy that have far-reaching, but little understood, consequences. In this article, I outline some of the ways central banks use their power to influence markets and society as a whole through their collateral policies.

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