Closely related is the liquidity channel, which comes into play at the start of the transmission mechanism, influencing short-term interest rates beyond the conditions set by policy rates. Government bonds are often used as collateral for banks’ refinancing operations. In fact, government bonds are the primary collateral used in the secured interbank market.
If government bond markets are disrupted, this hampers the functioning of the interbank market and reduces liquidity in this market. The consequences are increased money market rates due to premia for liquidity risk. As a result, the capacity of banks to issue loans and refinance the real economy suffers.