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Endogenous Exposure to Systemic Liquidity Risk

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  • Jin Cao

    (Norges Bank)

  • Gerhard Illing

    (Department of Economics, University of Munich and CESifo)

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Abstract

Traditionally, aggregate liquidity shocks are modeled as exogenous events. This paper analyzes the adequate policy response to endogenous exposure to systemic liquidity risk. We analyze the feedback between lender-of-last-resort policy and incentives of private banks, determining the aggregate amount of liquidity available. We show that imposing minimum liquidity standards for banks ex ante is a crucial requirement for sensible lender-of-last-resort policy. In addition, we analyze the impact of equity requirements and narrow banking, in the sense that banks are required to hold sufficient liquid funds so as to pay out in all contingencies. We show that both policies are strictly inferior to imposing minimum liquidity standards ex ante combined with lender-of-last-resort policy.

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Bibliographic Info

Article provided by International Journal of Central Banking in its journal International Journal of Central Banking.

Volume (Year): 7 (2011)
Issue (Month): 2 (June)
Pages: 173-216

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Handle: RePEc:ijc:ijcjou:y:2011:q:2:a:6

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Cited by:
  1. Diana Bonfim & Moshe Kim, 2012. "Liquidity risk in banking: is there herding?," Working Papers w201218, Banco de Portugal, Economics and Research Department.
  2. Franklin Allen & Elena Carletti & Douglas Gale, 2011. "Money, Financial Stability and Efficiency," Economics Working Papers ECO2011/04, European University Institute.

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