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Endogenous Systemic Liquidity Risk

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  • Cao, Jin
  • Illing, Gerhard
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Abstract

Traditionally, aggregate liquidity shocks are modelled as exogenous events. Extending our previous work (Cao & Illing, 2007), this paper analyses the adequate policy response to endogenous systemic liquidity risk. We analyse 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 are a crucial requirement for sensible lender of last resort policy. In addition, we analyse 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 such a policy is strictly inferior to imposing minimum liquidity standards ex ante combined with lender of last resort policy.

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Paper provided by University of Munich, Department of Economics in its series Discussion Papers in Economics with number 3358.

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Date of creation: 21 Apr 2008
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Handle: RePEc:lmu:muenec:3358

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Keywords: Liquidity risk; Free-riding; Narrow banking; Lender of last resort;

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  1. Hart, O. & Moore, J., 1991. "A Theory of Debt Based on the Inalienability of Human Capital," Working papers 592, Massachusetts Institute of Technology (MIT), Department of Economics.
  2. Bengt Holmstrom & Jean Tirole, 1996. "Private and Public Supply of Liquidity," NBER Working Papers 5817, National Bureau of Economic Research, Inc.
  3. Illing, Gerhard & Cao, Jin, 2007. "Liquidity Shortages and Monetary Policy," Discussion Papers in Economics 2008, University of Munich, Department of Economics.
  4. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
  5. Douglas W. Diamond & Raghuram G. Rajan, 2003. "Money in a Theory of Banking," NBER Working Papers 10070, National Bureau of Economic Research, Inc.
  6. Douglas W. Diamond & Raghuram G. Rajan, 1999. "Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking," NBER Working Papers 7430, National Bureau of Economic Research, Inc.
  7. Douglas W. Diamond & Raghuram G. Rajan, 2005. "Liquidity Shortages and Banking Crises," Journal of Finance, American Finance Association, vol. 60(2), pages 615-647, 04.
  8. Franklin Allen & Douglas Gale, 2004. "Financial Intermediaries and Markets," Econometrica, Econometric Society, vol. 72(4), pages 1023-1061, 07.
  9. Rochet, Jean-Charles, 2004. "Macroeconomic shocks and banking supervision," Journal of Financial Stability, Elsevier, vol. 1(1), pages 93-110, September.
  10. Goodhart, Charles & Illing, Gerhard (ed.), 2002. "Financial Crises, Contagion, and the Lender of Last Resort: A Reader," OUP Catalogue, Oxford University Press, number 9780199247219, September.
  11. Franklin Allen & Douglas Gale, 1998. "Optimal Financial Crises," Journal of Finance, American Finance Association, vol. 53(4), pages 1245-1284, 08.
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