Impact of monetary policy on collateral reuse

ABSTRACT Rehypothecation is the direct reuse of collateral received by a lender to borrow on;their own account from a third party. It enables the intermediate lender to maximize;investment in their profitable project by making efficient use of the collateral. I show;that when a central bank removes collateral from the market through an open market;operation, less collateral is available to be borrowed by the productive intermediate;lenders, leading to retarded investment by them and lower aggregate output. This is;due to a pecuniary externality: the presence of other competing lenders increases the;cost of rehypothecation for the productive lenders to inefficient levels. I find empirical;evidence for this channel in the cost of borrowing in the bilateral repurchase agreement;(repo) market. The policy implications of this result include conducting open market;operations when collateral is abundant and the repo rate is high. It also suggests that;using interest on reserves may be more effective as a policy tool compared with open;market operations when collateral is scarce.