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Regulation of systemic liquidity risk

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  • Jin Cao
  • Gerhard Illing

Abstract

This paper provides a baseline model for regulatory analysis of systemic liquidity shocks. We show that banks may have an incentive to invest excessively in illiquid long-term projects. In the prevailing mixed-strategy equilibrium, the allocation is inferior from the investor’s point of view since some banks free ride on the liquidity provision due to their limited liability. The paper compares different regulatory mechanisms to cope with the externalities. We show that a combination of liquidity regulation ex ante and lender of last resort policy ex post can maximize investor payoff. In contrast, both “narrow banking” and imposing equity requirements as a buffer are inferior mechanisms for coping with systemic liquidity risk. Copyright Swiss Society for Financial Market Research 2010

Suggested Citation

  • Jin Cao & Gerhard Illing, 2010. "Regulation of systemic liquidity risk," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 24(1), pages 31-48, March.
    • Handle: RePEc:kap:fmktpm:v:24:y:2010:i:1:p:31-48
    DOI: 10.1007/s11408-009-0126-x
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    Cited by:

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    2. Diana Bonfim & Moshe Kim, 2012. "Systemic Liquidity Risk," Economic Bulletin and Financial Stability Report Articles and Banco de Portugal Economic Studies, Banco de Portugal, Economics and Research Department.
    3. Roberts, Daniel & Sarkar, Asani & Shachar, Or, 2023. "Liquidity regulations, bank lending and fire-sale risk," Journal of Banking & Finance, Elsevier, vol. 156(C).
    4. Ellis, Scott & Sharma, Satish & Brzeszczyński, Janusz, 2022. "Systemic risk measures and regulatory challenges," Journal of Financial Stability, Elsevier, vol. 61(C).
    5. de la Torre, Augusto & Ize, Alain, 2013. "The foundations of macroprudential regulation : a conceptual roadmap," Policy Research Working Paper Series 6575, The World Bank.
    6. Diana Bonfim & Moshe Kim, 2012. "Liquidity risk in banking: is there herding?," Working Papers w201218, Banco de Portugal, Economics and Research Department.
    7. Silva, Walmir & Kimura, Herbert & Sobreiro, Vinicius Amorim, 2017. "An analysis of the literature on systemic financial risk: A survey," Journal of Financial Stability, Elsevier, vol. 28(C), pages 91-114.

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    More about this item

    Keywords

    Liquidity regulation; Systemic risk; Lender of last resort; Deposit insurance; Financial stability; E5; G21; G28;
    All these keywords.

    JEL classification:

    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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