(Revised August 21, 2026)

Central banks can harness the power of arbitrage to restore market liquidity during financial crises. When doing so, central banks face a tradeoff between liquidity provision and potential losses induced by moral hazard. We use novel data from the Term Asset-Backed Securities Loan Facility (TALF) to test predictions of the limits-to-arbitrage literature. We show that liquidity provision lowers spreads, especially for riskier securities. However, mitigating moral hazard—rejecting some collateral—reduces the participation of capital-constrained arbitrageurs and thereby the effectiveness of central bank liquidity provision. Only when capital constraints ease do constrained arbitrageurs again take more risk.