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Inefficient liquidity creation

Author

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  • Luck, Stephan
  • Schempp, Paul

Abstract

We present a model in which intermediaries create liquidity by issuing safe debt. Two types of intermediaries emerge: Traditional banks that create liquidity by issuing equity and holding assets to maturity, and market-based intermediaries that create liquidity by selling assets in fire sales in downturns. We show that the reliance on market-based intermediation is necessarily too high, but liquidity creation is not. It can also be too low as the endogenous fire-sale risk can push liquidity creation below its optimum. We argue that standard capital or liquidity regulation are ineffective, and optimal macroprudential regulation should instead target market-based intermediation.

Suggested Citation

  • Luck, Stephan & Schempp, Paul, 2023. "Inefficient liquidity creation," Journal of Financial Intermediation, Elsevier, vol. 53(C).
    • Handle: RePEc:eee:jfinin:v:53:y:2023:i:c:s1042957322000493
    DOI: 10.1016/j.jfi.2022.100996
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    References listed on IDEAS

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    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Banking; Macroprudential regulation; Liquidity creation; Fire sales; Pecuniary externalities; Shadow banking; Regulatory arbitrage;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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