At the end of 2011 and the beginning of 2012, the ECB provided European commercial banks approximately 1000 billion euros in liquidity under the LTRO program, against eligible collateral (mostly in the form of government bonds). In this paper I investigate the macroeconomic consequences of emergency liquidity provision by the Central Bank. I construct a DSGE model that contains balance sheet constrained  financial intermediaries that finance private loans and government bonds subject to sovereign default risk. Commercial banks have access to CB liquidity facilities, but have to provide government bonds as collateral. The interest rate on these liquidity facilities is lowered in times of financial crisis with respect to the interest rate on regular market funding. I calibrate the model on the European periphery. I find that decreasing the interest rate on the liquidity facilities induces a shift out of private loans and into government bonds, in order to increase access to emergency liquidity funding. This has a negative effect on the real economy in the short run, due to crowding out of private loans. Lower funding costs, however, restore bank balance sheets faster, and allow the economy to recover faster in the long run. My results therefore indicate that the LTRO operation might initially have aggravated the economic contraction, but has possibly contributed to the recovery in the long run. The policy can be viewed as an indirect recapitalization of the commercial banks by the CB. I compare the emergency liquidity provision by the CB with a debt-financed recapitalization, and find that a recapitalization is more effective because it directly alleviates bank balance sheet constraints by providing new net worth, without the need for commercial banks to shift into government bonds. Such a direct recapitalization might not always be feasible, as the recapitalization attempt by the Spanish sovereign in May 2012 demonstrated, in which case an indirect recapitalization through subsidized CB liquidity provision would be a feasible alternative.

Field: Macroeconomics