Central banks never lend funds unsecured. Every transaction—from routine open market operations to emergency liquidity assistance—requires the commercial bank to pledge eligible collateral to protect the central bank from credit losses.

To account for market and liquidity risks, central banks apply percentage-based discounts, known as Haircuts, to the value of pledged assets:

Adjusted Collateral Valuation = Market Value of Asset * (1 - Assigned Haircut Decimal)

For example, if a bank pledges a package of asset-backed securities with a market value of $20,000,000, and the central bank’s eligibility guidelines assign a 15% (0.15) haircut due to liquidity risks, the plain-text valuation calculation is:

Adjusted Collateral Valuation = 20,000,000 * (1 - 0.15) = 20,000,000 * 0.85 = $17,000,000

High-quality, highly liquid assets like sovereign bonds receive low haircuts, while complex, illiquid corporate bonds receive high haircuts, encouraging banks to maintain a high-quality asset base.