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Liquidity policies and systemic risk

The growth of wholesale-funded credit intermediation has motivated liquidity regulations. We analyze a dynamic stochastic general equilibrium model in which liquidity and capital regulations interact with the supply of risk-free assets. In the model, the endogenously time-varying tightness of liquidity and capital constraints generates intermediaries’ leverage cycle, influencing the pricing of risk and the level of risk in the economy. Our analysis focuses on liquidity policies’ implications for household welfare. Within the context of our model, liquidity requirements are preferable to capital requirements, as tightening liquidity requirements lowers the likelihood of systemic distress without impairing consumption growth. In addition, we find that intermediate ranges of risk-free asset supply achieve higher welfare.

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Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 661.

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Length: 44 pages
Date of creation: 01 Dec 2014
Date of revision:
Handle: RePEc:fip:fednsr:661
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  1. Cao, Jin & Illing, Gerhard, 2010. "Regulation of systemic liquidity risk," Munich Reprints in Economics 19999, University of Munich, Department of Economics.
  2. Kahn, Charles M. & Santos, Joao A.C., 2005. "Allocating bank regulatory powers: Lender of last resort, deposit insurance and supervision," European Economic Review, Elsevier, vol. 49(8), pages 2107-2136, November.
  3. Holmstrom, B & Tirole, J, 1996. "Private and Public Supply of Liquidity," Working papers 96-21, Massachusetts Institute of Technology (MIT), Department of Economics.
  4. Charles Goodhart & Anil K Kashyap & Dimitrios Tsomocos & Alexandros Vardoulakis, 2012. "Financial Regulation in General Equilibrium," FMG Discussion Papers dp702, Financial Markets Group.
  5. Tobias Adrian & Nina Boyarchenko, 2012. "Intermediary leverage cycles and financial stability," Staff Reports 567, Federal Reserve Bank of New York.
  6. Jin Cao & Gerhard Illing, 2010. "Regulation of systemic liquidity risk," Financial Markets and Portfolio Management, Springer, vol. 24(1), pages 31-48, March.
  7. Enrique G. Mendoza & Javier Bianchi, 2011. "Overborrowing, Financial Crises and ‘Macro-Prudential’ Policy?," IMF Working Papers 11/24, International Monetary Fund.
  8. Enrico Perotti & Javier Suarez, 2011. "A Pigovian Approach to Liquidity Regulation," DNB Working Papers 291, Netherlands Central Bank, Research Department.
  9. Zhiguo He & Arvind Krishnamurthy, 2013. "Intermediary Asset Pricing," American Economic Review, American Economic Association, vol. 103(2), pages 732-70, April.
  10. Hayne E. Leland and Klaus Bjerre Toft., 1995. "Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads," Research Program in Finance Working Papers RPF-259, University of California at Berkeley.
  11. Javier Bianchi & Enrique G. Mendoza, 2011. "Overborrowing, Financial Crises and 'Macro-prudential' Policy," 2011 Meeting Papers 175, Society for Economic Dynamics.
  12. Enrico Perotti & Javier Suarez, 2011. "A Pigovian Approach to Liquidity Regulation," Tinbergen Institute Discussion Papers 11-040/2/DSF15, Tinbergen Institute.
  13. Ratnovski, Lev, 2009. "Bank liquidity regulation and the lender of last resort," Journal of Financial Intermediation, Elsevier, vol. 18(4), pages 541-558, October.
  14. Rochet, J C., 2008. "Liquidity regulation and the lender of last resort," Financial Stability Review, Banque de France, issue 11, pages 45-52, February.
  15. Korinek, Anton, 2011. "Systemic risk-taking: amplification effects, externalities, and regulatory responses," Working Paper Series 1345, European Central Bank.
  16. repec:dgr:uvatin:20110040 is not listed on IDEAS
  17. repec:dgr:uvatin:2011040 is not listed on IDEAS
  18. Tobias Adrian & Hyun Song Shin, 2010. "The changing nature of financial intermediation and the financial crisis of 2007-09," Staff Reports 439, Federal Reserve Bank of New York.
  19. Alexandros Vardoulakis, 2012. "Financial regulation in general equilibrium," Chapters in SUERF Studies, SUERF - The European Money and Finance Forum.
  20. Adrian, Tobias & Boyarchenko, Nina, 2013. "Intermediary balance sheets," Staff Reports 651, Federal Reserve Bank of New York.
  21. Cox, John C. & Huang, Chi-fu, 1989. "Optimal consumption and portfolio policies when asset prices follow a diffusion process," Journal of Economic Theory, Elsevier, vol. 49(1), pages 33-83, October.
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