Put simply, collateral is an item of value that a lender can seize from a borrower if he or she fails to repay a loan according to the agreed terms. One common example is when you take out a mortgage. Normally, the bank will ask you to provide your home as collateral. This means that if you fail to meet the repayment terms of your mortgage, the bank has the right to take ownership of your home. The bank can then sell your home in order to recoup the money that it lent to you. Collateral acts as a guarantee that the lender will receive back the amount lent even if the borrower does not repay the loan as agreed.
Do central banks also ask for collateral when they lend?
Yes, central banks demand collateral when lending because hypothetical losses from lending could compromise their reputation and independence. When commercial banks seek funding from the ECB and the 19 national central banks that together form the Eurosystem, they must pledge collateral. The Eurosystem publishes a list of what it will accept as collateral, referred to as eligible assets. These assets may be bonds or other shorter-term securities that can be traded in the markets. Though not included in the list, other assets that are not typically traded – such as loans to the non-financial sector – can also be considered eligible for use as collateral when borrowing from the Eurosystem. The national central banks are responsible for deciding which assets qualify as eligible, in line with the Eurosystem collateral framework.
Source: European Central Bank
Published: 2 Nov 2016
The above presentation was created for educational purposes.