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Regulation of systemic liquidity risk

  • Jin Cao


  • Gerhard Illing


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    This 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 due to their limited liability. The paper compares different regulatory mechanisms to cope with the externalities. We show that a combination of liquidity regulation ex ante and lender of last resort policy ex post can maximize investor payoff. In contrast, both “narrow banking” and imposing equity requirements as a buffer are inferior mechanisms for coping with systemic liquidity risk. Copyright Swiss Society for Financial Market Research 2010

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    Article provided by Springer in its journal Financial Markets and Portfolio Management.

    Volume (Year): 24 (2010)
    Issue (Month): 1 (March)
    Pages: 31-48

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    Handle: RePEc:kap:fmktpm:v:24:y:2010:i:1:p:31-48
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    1. Franklin Allen & Douglas Gale, 1976. "Optimal Financial Crises," Center for Financial Institutions Working Papers 97-01, Wharton School Center for Financial Institutions, University of Pennsylvania.
    2. Holmstrom, B & Tirole, J, 1996. "Private and Public Supply of Liquidity," Working papers 96-21, Massachusetts Institute of Technology (MIT), Department of Economics.
    3. Douglas W. Diamond & Raghuram G. Rajan, 2003. "Money in a Theory of Banking," NBER Working Papers 10070, National Bureau of Economic Research, Inc.
    4. Acharya, Viral V., 2009. "A theory of systemic risk and design of prudential bank regulation," Journal of Financial Stability, Elsevier, vol. 5(3), pages 224-255, September.
    5. Gersbach, Hans, 2009. "Private Insurance Against Systemic Crises?," CEPR Discussion Papers 7342, C.E.P.R. Discussion Papers.
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