Regulation of Systemic Liquidity Risk
AbstractThe 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 as a result of limited liability. The paper compares different regulatory mechanisms to cope with the externalities. It is shown that the combination of liquidity regulation ex ante and lender of last resort policy ex post is able to implement the outcome maximizing investor’s payoff. In contrast, both “narrow banking” and imposing equity requirements as buffer are inferior mechanisms for coping with systemic liquidity risk.
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Bibliographic InfoPaper provided by University of Munich, Department of Economics in its series Discussion Papers in Economics with number 11306.
Date of creation: Jan 2010
Date of revision:
Liquidity Regulation; Systemic risk; Lender of last resort; Financial Stability;
Other versions of this item:
- 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
This paper has been announced in the following NEP Reports:
- NEP-ALL-2010-01-23 (All new papers)
- NEP-BAN-2010-01-23 (Banking)
- NEP-BEC-2010-01-23 (Business Economics)
- NEP-MAC-2010-01-23 (Macroeconomics)
- NEP-REG-2010-01-23 (Regulation)
- NEP-RMG-2010-01-23 (Risk Management)
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