Liquidity, Collateral Quality, and Interest Rates a

This paper analyzes how collateral quality shocks affect banks' liquidity management and the risk‐free rate. We develop a model where banks manage liquidity through near‐cash assets and marketable securities subject to idiosyncratic and/or aggregate shocks. Collateral quality deterioration leads to nonmonotonic changes in liquidity holdings: moderate declines reduce cash holdings via lower market returns, while severe declines cause precautionary hoarding and market freezes. Reduced collateral quality depresses the risk‐free rate. Liquidity regulation and negative interest rate policies can mitigate these effects. Our findings highlight the risks of collateral quality shocks and the importance of policy complementarities in addressing liquidity issues.