An Underestimated Policy Lever: The ECB’s Collateral Policy Supports Financial Markets and Reduces Uncertainty

Abstract

A central bank’s collateral policy determines which assets banks may use as collateral for refinancing operations. Thus, it is a critical tool for providing the banking system with liquidity while simultaneously stabilizing it. Using a high-frequency identification approach, this study examines how the European Central Bank’s collateral policy influences banks, financial markets, and government bond markets. When the ECB’s collateral policy is eased, bank stock prices rise more sharply than those of the overall market, market uncertainty declines, and the default risk of banks decreases, particularly for riskier banks. Furthermore, yield spreads between government bonds of euro area peripheral countries, such as Italy and Spain, and those of core euro area countries, such as Germany and France, narrow significantly. This asymmetric spillover from the banking system to government bond markets differs fundamentally from the effects of conventional monetary policy, such as adjustments to key interest rates, which affect euro area countries uniformly. In principle, this asymmetry between the eurozone’s peripheral and core countries can be counteracted through greater harmonization of banking regulation and insolvency law.