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The (unintended?) consequences of the largest liquidity injection ever

We study the design of lender of last resort interventions and show that the provision of long-term liquidity incentivizes purchases of high-yield short-term securities by banks. Using a unique security-level data set, we note that the European Central Bank's three-year Long-Term Refinancing Operation incentivized Portuguese banks to purchase short term domestic government bonds that could be pledged to obtain central bank liquidity. This “collateral trade" effect is large, as banks purchased short-term bonds equivalent to 8.4% of amount outstanding. The resumption of public debt issuance is consistent with a strategic reaction of the debt agency to the observed yield curve steepening.