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A Pigovian Approach to Liquidity Regulation

Author

Listed:
  • Enrico Perotti

    (University of Amsterdam, Duisenberg school of finance, and CEPR)

  • Javier Suarez

    (CEMFI, and CEPR)

Abstract

This paper discusses liquidity regulation when short-term funding enables credit growth but generates negative systemic risk externalities. It focuses on the relativemerit of price versus quantity rules, showing how they target different incentives for risk creation.When banks differ in credit opportunities, a Pigovian tax on short-term funding is efficient in containing risk and preserving credit quality, while quantity-based fundingratios are distorsionary. Liquidity buffers are either fully ineffective or similar to a Pigovian tax with deadweight costs. Critically, they may be least binding when excess credit incentives are strongest.When banks differ instead mostly in gambling incentives (due to low charter valueor overconfidence), excess credit and liquidity risk are best controlled with net fundingratios. Taxes on short-term funding emerge again as efficient when capital or liquidityratios keep risk shifting incentives under control. In general, an optimal policy shouldinvolve both types of tools. This discussion paper resulted in a publication in the (December 2011).

Suggested Citation

  • Enrico Perotti & Javier Suarez, 2011. "A Pigovian Approach to Liquidity Regulation," Tinbergen Institute Discussion Papers 11-040/2/DSF15, Tinbergen Institute.
  • Handle: RePEc:tin:wpaper:20110040
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    References listed on IDEAS

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    More about this item

    Keywords

    Systemic risk; Liquidity risk; Liquidity requirements; Liquidity risk levies; Macroprudential regulation;
    All these keywords.

    JEL classification:

    • 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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