Early on in the crisis the value of collateral deteriorated so dramatically that even the primary unsecured form of lending – interbank lending – ceased to function. Precautionary hoarding of liquidity brought about a complete seizure of many segments of the market for credit. At the same time, panic sales of assets made market liquidity disappear. Market liquidity is high when traders can easily find a price, and that price is very close to what every other trader pays for the same asset at the same time. In early October 2008 the market simply couldn’t find a value for many of those securities that had been so highly priced only a few weeks before. While available collateral was sharply down-priced, the economy-wide equity capital, which is largely valued by the market, evaporated in a matter of hours. Equity capital is what backs up unsecured money market transactions. This partly explains why the unsecured market seized up alongside the repo market. While collateralised finance can accelerate a generalised loss of confidence, it provides the guardians of stability with one more instrument of defence. In late 2008 the ECB increased its collateralised lending to compensate for the withdrawal of private lending in inter-bank transactions. To ease banks’ liquidity and balance sheet constraints, in particular, we have broadened the list of assets that we consider eligible as collateral in our refinancing operations. This has liquified a large fraction of our counterparties’ assets, which had become illiquid in the tense market conditions following the failure of Lehman.
For example, Adrian and Shin (2008) demonstrate that the balance sheets of US broker/dealers expand when monetary policy is accommodative. 6 Similar evidence is provided for the US repo market by Gorton and Metrick (2009), who found that activity started to increase significantly from 2001 – that is, at a time when monetary policy in the US was relatively loose following the bursting of the dot-com bubble. 7 Acharya and Schnabl (2010) provide similar evidence related to the asset-backed commercial paper (ABCP) market. 8 In summary, if the process that has been set in motion under the aegis of the G20 has the potential to place a whole new segment of finance under regulatory scrutiny and oversight, the new collateral-based finance can give a central bank stronger influence over financial and macroeconomic conditions more broadly. 5. Monetary policy in a high-debt environment  I mentioned earlier that collateral is likely to play a growing role in the functioning of capital markets. Demand for collateral is thus likely to increase. But, given the collapse of securitisation activity during the crisis, we could imagine that the current decline in the creation of securitised assets might become a permanent feature of the new landscape. There will be fewer ABSs created out of bank books. Sovereign debt will certainly be widespread. It will probably replace ABSs in the collateralisation of secured lending. Unlike in the past, the risk characteristics of this type of debt instrument will be more graduated than was considered possible only few years ago.