We take a macroprudential approach to analyze the optimal lending policy for the central lending facilities collateral protects central banks against losses, but can adversely affect liquidity creation in markets since high-quality collateral gets locked up with the central bank rather than circulating in markets. Lending against low-quality collateral creates counterparty risk but can improve liquidity in markets. We characterize the optimal policy incorporating these trade-offs. We show that, contrary to what is generally accepted, lending against high-quality collateral can have negative effects, whereas it may be optimal to lend against low-quality collateral. 

Keywords: Central bank, liquidity, macroprudential policy, externality, interbank market, lending facilities