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Inefficiency and Regulation of Private Liquidity

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  • Benigno, Pierpaolo
  • Robatto, Roberto

Abstract

We propose a simple model to study the efficiency of liquidity creation by financial intermediaries, which can take the form of either safe or risky debt. Liquidity crises arise when risky debt is defaulted on and stops providing liquidity services. Owing to a novel externality related to liquidity premia and the cost of issuing safe debt, the laissez-faire equilibrium is inefficient, characterized by an excessive supply of risky debt. However, the optimal policy requires the regulation of safe debt as well. Capital requirements targeting risky debt alone have unintended welfare-reducing consequences.

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  • Benigno, Pierpaolo & Robatto, Roberto, 2019. "Inefficiency and Regulation of Private Liquidity," CEPR Discussion Papers 13631, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:13631
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    References listed on IDEAS

    as
    1. Gofman, Michael, 2017. "Efficiency and stability of a financial architecture with too-interconnected-to-fail institutions," Journal of Financial Economics, Elsevier, vol. 124(1), pages 113-146.
    2. Nataliya Klimenko & Sebastian Pfeil & Jean-Charles Rochet & Gianni De Nicolo, 2016. "Aggregate Bank Capital and Credit Dynamics," Swiss Finance Institute Research Paper Series 16-42, Swiss Finance Institute.
    3. Patrick Bolton & Xavier Freixas, 2000. "Equity, Bonds, and Bank Debt: Capital Structure and Financial Market Equilibrium under Asymmetric Information," Journal of Political Economy, University of Chicago Press, vol. 108(2), pages 324-351, April.
    4. Frederic Malherbe, 2014. "Self-Fulfilling Liquidity Dry-Ups," Journal of Finance, American Finance Association, vol. 69(2), pages 947-970, April.
    5. Benigno, Pierpaolo & Robatto, Roberto, 2019. "Private money creation, liquidity crises, and government interventions," Journal of Monetary Economics, Elsevier, vol. 106(C), pages 42-58.
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