How do central bank collateral frameworks affect non-financial firms?

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Central banks implement financial policy by extending credit to banks, for instance via standing facilities or lengthy-term refinancing operations. Additionally to setting policy rates, central banks also specify within their collateral framework which financial assets banks can pledge to acquire central bank funding. Ideas discuss the style of collateral frameworks for that situation of corporate sector assets. Many of the relevant in countries in which the way to obtain safe government bonds is inadequate to satiate collateral demand.

Since corporate sector assets are susceptible to default risk, central banks expose themselves to additional risks when accepting these assets as collateral. Therefore, corporate bonds are just qualified as collateral when they satisfy the absolute minimum rating requirement. Throughout the economic crisis of 2008/09, several central banks began accepting corporate bonds and related debt instruments or relaxed the eligibility needs for such assets (see table 1). By extending the swimming pool of qualified assets, this so-known as collateral easing policy ensures smooth conduct of financial policy.

Table 1. Non-Financial Corporate Bonds in Various Collateral Frameworks

 Central Bank  Pre GFC  Post GFC  Post Covid-19
 (Min. Rating)  (Min. Rating)  (Min. Rating)
 Australia  No  Yes (AAA)  Yes (BBB)
 Eurosystem  Yes (A)  Yes (BBB)  Yes (BB, temporarily)
 Japan  Yes (A)  Yes (BBB)  Yes (BBB)
 Switzerland  Yes (AA)  Yes (AA)  Yes (AA)
 United Kingdom  No  Yes (A)  Yes (A)
 United States  Yes (AAA)  Yes (AAA)  Yes (BBB)

Assessing the results of collateral easing should also consider endogenous responses from the non-financial sector – the collateral supply side. These responses originate from the eligibility premia that banks are prepared to purchase holding qualified assets and therefore are documented in Todorov (2020), Pelizzon et al. (2020) and Mesonnier et al. (2021). Grosse Rueschkamp et al. (2019) reveal that especially highly regarded firms react to lower eligibility needs by growing their debt issuance and leverage, which has unwanted effects on their own repayment performance.1

Within our new paper, we read the impact of eligibility needs around the debt issuance and default chance of firms and discuss how relevant these firm responses are suitable for the potency of collateral easing. Our analysis is dependant on an engaged corporate capital structure model, augmented by eligibility premia. These premia lessen the costs of debt financing and for that reason make debt issuance more appealing. We organize our analysis round the qualified debt capacity, which we define as the quantity of bonds firms can issue before shedding underneath the minimum rating needs.

Lucrative firms – that do not exhaust their qualified debt capacity – react to collateral easing by growing their debt issuance: a danger-taking effect. Individuals firms make the most of cheaper debt financing while increasing dividends. By comparison, less lucrative firms react to the possibilities of eligibility by constraining their debt option to take advantage of the eligibility premia banks are prepared to pay on their own bonds: a disciplining effect.2

Then we assess the results of collateral easing from the to BBB – in conjuction with the European Central Bank’s policy in 2008 – with the lenses in our model. A discount from the minimum rating for eligibility robotically boosts the way to obtain collateral with a substantial amount. Simultaneously, endogenous firm responses come with an adverse impact on collateral supply. While the quantity of corporate bonds outstanding rises, elevated default risk (and also the connected rating downgrades) depresses the quantity of qualified bonds. In line with empirical evidence in the firm level, the danger-taking effect exceeds the disciplining impact on the macroeconomic level. We illustrate the macroeconomic relevance of firm responses in figure 1: the particular collateral supply is marked in blue, and also the orange bars represent the furthermore available collateral within the hypothetical scenario where firms don’t change their behavior as a result of collateral easing.

Figure 1. Collateral supply within the euro area with time

A bar chart showing Figure 1: Collateral supply within the euro area with time

The dampening aftereffect of firm responses is connected using the debt-overhang problem that eligibility inflicts on high-rated firms: growing leverage in periods of high profitability has little impact on their current default risk and, therefore, allows firms to improve current dividends. Ultimately, however, firms are experiencing periods of low profitability – for instance, if their business models deteriorate or their goods become unfashionable. This will make their legacy debt unsustainable, so that firms drop underneath the minimum rating requirement or perhaps default. The actual reason behind these dynamics may be the “stickiness of leverage” (see Gomes et al. 2016).3

Firm responses have an effect on the central bank trade-off that guides the look collateral frameworks: growing the availability of collateral ensures smooth conduct of financial policy as the overall riskiness around the corporate bond market increases . Although our results claim that central banks should think about firm responses when making their collateral frameworks, we propose a possible instrument to mitigate adverse collateral quality effects: conditioning eligibility on current leverage additionally to current ratings provides incentives to deleverage if firm profitability deteriorates and therefore softens the adverse effects from the debt overhang. Used, such conditioning could be implemented by rating outlooks additionally to current ratings. Our model predicts that the optimally designed eligibility covenant might have elevated collateral supply by 12%, equal to EUR 225 billion for that euro area in ’09.

Finally, our paper talks to the continuing discussion on eco-friendly central banking. This insurance policy should really stimulate an investment of eco-friendly firms by relaxing their financing conditions through preferential treatment in collateral frameworks. Our analysis shows that there might be nonnegligible feedbacks from firm high risk to collateral supply and financial stability. We explore the potency of this insurance policy instrument at length inside a related paper (Giovanardi, Kaldorf, Radke, and Wicknig 2021).

References

Bekkum, Sjoerd van, Marc Gabarro, and Rustom M Irani (2018). “Does a bigger menu increase appetite? Collateral eligibility and credit supply.” Overview of Financial Studies 31(3), 943-979.

Giovanardi, Francesco, Matthias Kaldorf, Lucas Radke, and Florian Wicknig (2021). “The Preferential Management of Eco-friendly Bonds.” Working Paper.

Gomes, Joao, Urban Jermann, and Lukas Schmid (2016). “Sticky Leverage.” American Economic Review 106(12), 3800-3828.

Grosse-Rueschkamp, Benjamin, Sascha Steffen, and Daniel Streitz (2019). “A Capital Structure Funnel of Financial Policy.” Journal of monetary Financial aspects 133(2), 357-378.

Kaldorf, Matthias and Florian Wicknig (2021). “Risky Financial Collateral, Firm Heterogeneity, and also the Impact of Eligibility Needs.” Working Paper.

Mesonnier, Jean-Stephane, Charles O’Donnell, and Olivier Toutain (2021). “The Interest to be Qualified.” Journal of cash, Credit and Banking.

Pelizzon, Loriana, Max Riedel, Zorka Simon, and Marti Subrahmanyan (2020). “The Corporate Debt Supply Results of the Eurosystem’s Collateral Framework.” Working Paper.

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