Collateral rehypothecation, safe asset scarcity, and unconventional monetary policy

We build a mark-to-market model where commercial banks can enlarge their balance sheets, repledging the available collateral several times to exchange liquidity through the interbank market. In bad times, the fall of risky asset price disrupts the length of the repledging chain due to the increase of the haircut and the decrease of external assets’ value. In such a scenario, the central bank can intervene implementing unconventional monetary policies by purchasing a fraction of the banking system’s external assets, both safe treasury bonds, and risky asset-backed securities, to inject liquidity. Our results show that a quantitative easing policy that purchases only safe assets is highly ineffective in restoring the intermediation activity to the pre-crisis level due to its inability to sustain the risky asset price and the repledging chain of collateral. Instead, focusing on risky assets only, the monetary authority can sustain risky asset prices, avoiding the freezing of the money market.