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A Pigovian Approach to Liquidity Regulation

  • Enrico Perotti
  • Javier Suarez

This paper discusses liquidity regulation when short-term funding enables credit growth but generates negative systemic risk externalities. It focuses on the relative merit 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 funding ratios 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 value or overconfidence), excess credit and liquidity risk are best controlled with net funding ratios. Taxes on short-term funding emerge again as efficient when capital or liquidity ratios keep risk shifting incentives under control. In general, an optimal policy should involve both types of tools.

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File URL: http://www.dnb.nl/en/binaries/Working%20Paper%20291_tcm47-253004.pdf
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Paper provided by Netherlands Central Bank, Research Department in its series DNB Working Papers with number 291.

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Date of creation: Apr 2011
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Handle: RePEc:dnb:dnbwpp:291
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Web page: http://www.dnb.nl/en/

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  1. Olivier Jeanne & Anton Korinek, 2010. "Managing Credit Booms and Busts: A Pigouvian Taxation Approach," NBER Working Papers 16377, National Bureau of Economic Research, Inc.
  2. Huang, Rocco & Ratnovski, Lev, 2011. "The dark side of bank wholesale funding," Journal of Financial Intermediation, Elsevier, vol. 20(2), pages 248-263, April.
  3. Allen, F. & Babus, A. & Carletti, E., 2010. "Financial Connections and Systemic Risk," Discussion Paper 2010-88S, Tilburg University, Center for Economic Research.
  4. Allen, Franklin & Babus, Ana & Carletti, Elena, 2010. "Financial Connections and Systemic Risk," Working Papers 10-20, University of Pennsylvania, Wharton School, Weiss Center.
  5. Viral V. Acharya, 2010. "Measuring systemic risk," Proceedings 1140, Federal Reserve Bank of Chicago.
  6. Segura, Anatoli & Suarez, Javier, 2011. "Liquidity shocks, roll-over risk and debt maturity," CEPR Discussion Papers 8324, C.E.P.R. Discussion Papers.
  7. Acharya, Viral V & Gale, Douglas M & Yorulmazer, Tanju, 2009. "Rollover Risk and Market Freezes," CEPR Discussion Papers 7122, C.E.P.R. Discussion Papers.
  8. Viral V. Acharya & Ouarda Merrouche, 2010. "Precautionary Hoarding of Liquidity and Inter-Bank Markets: Evidence from the Sub-prime Crisis," NBER Working Papers 16395, National Bureau of Economic Research, Inc.
  9. Luc Laeven & Fabian Valencia, 2010. "Resolution of Banking Crises; The Good, the Bad, and the Ugly," IMF Working Papers 10/146, International Monetary Fund.
  10. repec:dgr:kubcen:2010108s is not listed on IDEAS
  11. repec:fip:fedhpr:y:2010:i:may:p:65-71 is not listed on IDEAS
  12. Anatoli Segura & Javier Suarez, 2011. "Dynamic Maturity Transforation," Working Papers wp2011_1105, CEMFI.
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