Central Bank Collateral Frameworks: What Assets Are Eligible?

Central banks use collateral frameworks to define which assets banks can pledge to borrow funds in the overnight market or during a crisis. The framework specifies eligible securities, applies haircuts (discounts that reflect risk), and adjusts both during financial stress to prevent bank runs while maintaining control over money creation.

Why Central Banks Control Collateral

Commercial banks do not keep enough cash on hand to cover every withdrawal or every business day’s settlement obligations. They finance themselves in the wholesale money market—borrowing from other banks, institutional investors, and ultimately from the central bank. These borrowings are short-term (overnight, one week, or one month) and secured by collateral.

A central bank’s collateral framework serves two purposes:

Risk Control: By accepting only certain assets as collateral and applying haircuts, the central bank limits its own exposure if a borrowing bank fails. If a bank pledges $100 million in risky corporate bonds and then collapses, the central bank does not want to discover that the bonds are now worth only $50 million; the haircut pre-emptively accounts for this risk.

Monetary Control: By controlling which assets are eligible and at what haircut, the central bank influences the cost of liquidity for banks. A bank holding only ineligible collateral (illiquid assets, low-rated bonds) must either sell them at a loss, use eligible collateral more sparingly, or reduce lending. A bank holding high-quality collateral can borrow freely. This mechanism encourages banks to hold liquid, safe assets.

Typical Eligible Collateral

Central banks operate on a tiered system:

Tier 1 (Lowest Risk): Government securities (Treasury bonds, Gilts, Bunds), central bank reserves, currency. These face minimal or zero haircut because governments rarely default and their bonds are instantly tradeable.

Tier 2 (Moderate Risk): Investment-grade corporate bonds (rated BBB- or higher), mortgage-backed securities issued by government-sponsored enterprises, covered bonds (mortgages bundled and securitized with bank guarantees).

Tier 3 (Higher Risk): Below-investment-grade corporate bonds, equities, or other specialized instruments. These face steep haircuts or are ineligible during normal times but may be accepted during emergencies.

The Federal Reserve, European Central Bank, and Bank of England all maintain detailed lists specifying eligible instruments, rating thresholds, and haircut percentages.

Haircuts: The Risk Premium

A haircut is a discount applied to an asset’s market value when it is pledged as collateral. For example, if a government bond trades at $100 in the market and the central bank applies a 2% haircut, the bank can borrow only $98 against that bond.

Haircuts reflect several risks:

• Credit risk: The likelihood the issuer will default (lower for governments, higher for corporates)
• Market risk: How much the asset’s price might fall if sold quickly (higher for volatile bonds, equities)
• Liquidity risk: How easily the asset can be sold; illiquid assets face higher haircuts
• Basis risk: For structured products, the risk that the collateral’s true value diverges from the market price

A low-rated corporate bond might have a 15% haircut, meaning a $100 bond is valued at $85. A Treasury bond might have a 0.5% haircut. The differences reflect real economic differences in risk.

Haircuts are regularly reviewed and adjusted based on market volatility, historical price movements, and the central bank’s risk tolerance. They are typically calibrated so that even in a sharp market downturn (say, 10–15% price decline for corporate bonds), the collateral’s remaining value covers the loan.

Normal vs. Crisis Framework: The Expansion

During normal economic times, central banks are conservative. Eligibility is narrow, and haircuts are high. This incentivizes banks to hold safe, liquid collateral and discourages excessive risk-taking.

When a financial crisis hits—a bank run, a systemic shock, a sharp market decline—the central bank faces a dilemma. Strict collateral rules can worsen the crisis by denying liquidity to solvent banks that temporarily lack eligible collateral. If a bank holds loans or illiquid assets that are ultimately sound but cannot be pledged, it may face a liquidity crisis even though it is not insolvent.

Central banks respond by expanding the framework:

• Widen eligible collateral: Include lower-rated bonds, equities, or specialized assets previously ineligible.
• Reduce haircuts: A bond that normally faces 10% haircut might face only 5% during a crisis, allowing banks to borrow more.
• Lower lending rates: Reduce the interest rate the central bank charges, making borrowing cheaper.
• Increase loan sizes and maturities: Allow banks to borrow larger amounts for longer periods.

This expansion is deliberate and temporary. It signals to the market: “We will not let solvent banks fail due to a liquidity squeeze.” The ECB did this extensively during the 2008 financial crisis and again during the 2020 COVID shock, accepting a much broader range of collateral at lower haircuts.

However, expanding the framework is politically contentious. Conservative central bankers worry that accepting risky collateral or reducing haircuts amounts to subsidizing bad lending decisions. If a bank loaded up on junk bonds and the central bank then accepts those bonds at favorable terms, the bank is bailed out indirectly. The expansion can also inflate asset prices if banks use the borrowed liquidity to buy back equities or speculate rather than lend to the real economy.

The Federal Reserve’s Framework

The Federal Reserve accepts a range of collateral in its open-market operations (OMOs) and emergency lending facilities:

• Tier 1: Treasury securities, federal agency debt, cash
• Tier 2: Investment-grade corporate bonds, mortgage-backed securities, agency-guaranteed securities
• Tier 3: Lower-rated corporates and equities (typically only in emergency programs)

Haircuts vary by asset class and maturity. A 30-year Treasury might have a 2% haircut; a 5-year investment-grade corporate might have 5%; a mortgage-backed security might have 4%. During the 2008 crisis, the Fed accepted equities and many risky assets at favorable haircuts through emergency facilities.

The ECB’s Framework

The ECB, which lends to banks across the eurozone, maintains an even more complex framework. Eligible collateral includes:

• Marketable assets: Government bonds from eurozone countries (weighted by credit rating), corporate bonds, covered bonds
• Non-marketable assets: Bank loans to corporations and households (with strict quality requirements)

The ECB also uses credit assessment frameworks to rate collateral and assign haircuts. During the 2020 pandemic, the ECB dramatically lowered haircuts and accepted weaker collateral to ensure liquidity flowed to banks across the eurozone.

A controversial element: banks in countries with lower credit ratings (e.g., Italy) found their government bonds faced higher haircuts, making borrowing more expensive. This created spillovers where sovereign credit concerns affected bank liquidity.

Moral Hazard and the Backstop Problem

Expanding collateral frameworks during crises solves the immediate liquidity problem but creates a long-term incentive problem. If banks know the central bank will accept their collateral at favorable rates when trouble strikes, they are tempted to hold more risky assets in normal times, betting on a central bank rescue.

This is moral hazard: the assurance of a backstop changes behavior in ways that increase systemic risk. The central bank must balance immediate crisis response against long-term consequences.

In practice, central banks manage this by:

• Maintaining credibility: Making clear that the crisis expansion is temporary and that normal, stricter rules will return
• Stress-testing banks: Regularly assessing whether banks can survive an adverse scenario, discouraging excessive risk
• Regulatory oversight: Supervisory agencies (separate from the central bank’s monetary operations) set limits on how much risky collateral banks can hold

Recent Trends: Liquidity Stress and Digital Assets

In 2023, the failures of Silicon Valley Bank and other regional banks revealed that collateral frameworks themselves can be a vulnerability. Banks held large quantities of low-haircut government bonds, but when interest rates rose, the bonds’ market value plummeted. The central bank’s haircut was calculated assuming normal market stress, not the sudden, large repricing that occurred.

Central banks are reviewing haircut methodologies to account for rare but severe interest-rate shocks. Some are also exploring whether to accept digital assets (cryptocurrencies, stablecoins) as collateral. The ECB and Fed have been cautious, citing lack of maturity and volatility, but the conversation continues.

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