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Optimal liquidity policy with shadow banking

Author

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  • Borys Grochulski

    (Federal Reserve Bank of Richmond)

  • Yuzhe Zhang

    (Texas A&M University)

Abstract

We study the impact of shadow banking on optimal liquidity regulation in a Diamond–Dybvig maturity-mismatch environment. In this economy, a pecuniary externality arising out of the banks’ access to private retrade renders competitive equilibrium inefficient. A tax on illiquid assets and a subsidy to the liquid asset similar to the payment of interest on reserves (IOR) constitute an optimal liquidity regulation policy. Shadow banking gives banks an outside option allowing them to escape regulation at the cost of forgoing access to the government safety net. We derive two implications of shadow banking for optimal liquidity regulation policy. First, optimal policy must implement a macroprudential cap on illiquid-asset prices that binds only when the return on illiquid assets is high. Second, optimal policy must implement a fire sale of illiquid assets when high demand for liquidity is anticipated. We show how these features can be implemented by adjusting the IOR rate and the illiquid-asset tax rate.

Suggested Citation

  • Borys Grochulski & Yuzhe Zhang, 2019. "Optimal liquidity policy with shadow banking," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 68(4), pages 967-1015, November.
    • Handle: RePEc:spr:joecth:v:68:y:2019:i:4:d:10.1007_s00199-018-1152-6
    DOI: 10.1007/s00199-018-1152-6
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    2. Bengui, Julien & Bianchi, Javier, 2022. "Macroprudential policy with leakages," Journal of International Economics, Elsevier, vol. 139(C).
    3. Clayton, Christopher & Schaab, Andreas, 2023. "Regulation with Externalities and Misallocation in General Equilibrium," TSE Working Papers 23-1445, Toulouse School of Economics (TSE).

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    More about this item

    Keywords

    Maturity mismatch; Shadow banking; Mechanism design; Pecuniary externality; Private retrade; Liquidity regulation; Interest on reserves; Illiquid-asset tax;
    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
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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