Central banks and liquidity

I noted in an earlier post how the Fed has introduced a new instrument for liquidity in the present crisis, one intended to help prime brokerages.

There is a larger issue as to how central banks should address problems of liquidity. One school of thought is that they should do what the Fed has now done and what the European central bank has long done- that is, accept lower quality securities as collateral.

But this can only be a solution in a crisis. Once things settle down, banks must be incentivised to have adequate liquidity, else the assurance of greater liquidity in a crisis is bound to create moral hazard. Why would banks have adequate liquidity on their own when this means investing in low return assets?

Is the Fed compromising itself by offering government securities in return for lower grade securities held by banks and investment banks? No, says the Economist. The securities acceptable to the Fed are still AAA- rated bonds that are not on review for a downgrade. A 'haircut" will be applied to protect the Fed against a decline in the value of the collateral. And the Fed retains the right to demand other collateral if pledged collateral turns bad.