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Liquidity policies and systemic risk

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Abstract

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
Handle: RePEc:fip:fednsr:661
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Keywords: liquidity regulation; systemic risk; DSGE; financial intermediation;

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Find related papers by JEL classification:
  • E02 - Macroeconomics and Monetary Economics - - General - - - Institutions and the Macroeconomy
  • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
  • G00 - Financial Economics - - General - - - General
  • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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  1. Adrian, Tobias & Boyarchenko, Nina, 2012. "Intermediary leverage cycles and financial stability," Staff Reports 567, Federal Reserve Bank of New York, revised 01 Feb 2015.
  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. Javier Bianchi & Enrique G. Mendoza, 2011. "Overborrowing, Financial Crises and 'Macro-prudential' Policy," 2011 Meeting Papers 175, Society for Economic Dynamics.
  4. Adrian, Tobias & Boyarchenko, Nina, 2013. "Intermediary balance sheets," Staff Reports 651, Federal Reserve Bank of New York.
  5. Leland, Hayne E & Toft, Klaus Bjerre, 1996. " Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads," Journal of Finance, American Finance Association, vol. 51(3), pages 987-1019, July.
  6. 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.
  7. Rochet, J C., 2008. "Liquidity regulation and the lender of last resort," Financial Stability Review, Banque de France, issue 11, pages 45-52, February.
  8. Enrico Perotti & Javier Suarez, 2011. "A Pigovian Approach to Liquidity Regulation," International Journal of Central Banking, International Journal of Central Banking, vol. 7(4), pages 3-41, December.
  9. Jin Cao & Gerhard Illing, 2010. "Regulation of systemic liquidity risk," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 24(1), pages 31-48, March.
  10. Bengt Holmstrom & Jean Tirole, 1998. "Private and Public Supply of Liquidity," Journal of Political Economy, University of Chicago Press, vol. 106(1), pages 1-40, February.
  11. 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.
  12. Anton Korinek, 2011. "Systemic Risk-Taking: Amplification Effects, Externalities, and Regulatory Responses," NFI Working Papers 2011-WP-13, Indiana State University, Scott College of Business, Networks Financial 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. Charles A.E. Goodhart & Anil K Kashyap & Dimitrios P. Tsomocos & Alexandros P. Vardoulakis, 2012. "Financial Regulation in General Equilibrium," NBER Working Papers 17909, National Bureau of Economic Research, Inc.
  15. Alexandros Vardoulakis, 2012. "Financial regulation in general equilibrium," Chapters in SUERF Studies, SUERF - The European Money and Finance Forum.
  16. Zhiguo He & Arvind Krishnamurthy, 2013. "Intermediary Asset Pricing," American Economic Review, American Economic Association, vol. 103(2), pages 732-770, April.
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Cited by:

  1. Covas, Francisco & Driscoll, John C., 2014. "Bank Liquidity and Capital Regulation in General Equilibrium," Finance and Economics Discussion Series 2014-85, Board of Governors of the Federal Reserve System (U.S.).
  2. Kok, Christoffer & Darracq Pariès, Matthieu & Hałaj, Grzegorz, 2016. "Bank capital structure and the credit channel of central bank asset purchases," Working Paper Series 1916, European Central Bank.
  3. Adrian, Tobias, 2015. "Discussion of “Systemic Risk and the Solvency-Liquidity Nexus of Banks”," Staff Reports 722, Federal Reserve Bank of New York.

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