Does liquidity regulation reduce bank and systemic risk? Evidence from a quasi-natural experiment

This study uses a quasi-natural experimental research design exploiting the Dutch Liquidity Balance Rule (LBR) to evaluate the impacts of liquidity regulation on bank-level stability and systemic risk. Our findings show that following the introduction of the LBR, the stability of Dutch banks increases significantly relative to counterparts in neighboring countries unaffected by the regulation. The observed reduction in risk stems from improved capitalization and reduced leverage, which contribute to greater financial stability. Systemic risk also decreases. Dutch banks' vulnerability to systemic stress declines significantly, along with expected capital shortfalls, and their potential to transmit distress through the financial system diminishes. Our findings have relevance for policymakers tasked with implementing and monitoring the impacts of similar forms of liquidity regulation (such as bank liquidity coverage ratios) post global financial crisis. Specifically, adding liquidity regulation to pre-existing regulations is successful in mitigating risks that could propagate beyond the financial sector, and disrupt the real economy.