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Liquidity risk and financial stability regulation

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Abstract

We study banks' borrowing and investment decisions in an economy with pecuniary externalities and both aggregate and idiosyncratic liquidity risk. We show that private decisions by pro t-maximizing banks always result in socially inecient outcomes, but the nature of ineciency depends critically on the structure of liquidity risk. Overborrowing and overinvestment in risky assets arises only if idiosyncratic risk is suciently small. By contrast, if idiosyncratic risk is large, unregulated banks underborrow, underinvest and hold insucient liquidity reserves. A macroprudential regulator can restore constrained eciency by imposing countercyclical reserve requirements. Pigouvian taxes or bank capital requirements cannot achieve this objective.

Suggested Citation

  • Paul Pichler & Flora Lutz, 2017. "Liquidity risk and financial stability regulation," Vienna Economics Papers 1701, University of Vienna, Department of Economics.
  • Handle: RePEc:vie:viennp:1701
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    File URL: http://homepage.univie.ac.at/Papers.Econ/RePEc/vie/viennp/vie1701.pdf
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    References listed on IDEAS

    as
    1. 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.
    2. Eugenio Cerutti & Ricardo Correa & Elisabetta Fiorentino & Esther Segalla, 2017. "Changes in Prudential Policy Instruments - A New Cross-Country Database," International Journal of Central Banking, International Journal of Central Banking, vol. 13(2), pages 477-503, March.
    3. Hans Gersbach & Jean-Charles Rochet, 2012. "Aggregate Investment Externalities and Macroprudential Regulation," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 44, pages 73-109, December.
    4. Gazi Kara & S. Mehmet Ozsoy, 2016. "Bank regulation under fire sale externalities," Finance and Economics Discussion Series 2016-026, Board of Governors of the Federal Reserve System (U.S.).
    5. Emmanuel Farhi & Ivan Werning, 2012. "Dealing with the Trilemma: Optimal Capital Controls with Fixed Exchange Rates," NBER Working Papers 18199, National Bureau of Economic Research, Inc.
    Full references (including those not matched with items on IDEAS)

    More about this item

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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