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Endogenous systemic liquidity risk

  • Cao, Jin
  • Illing, Gerhard
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Traditionally, aggregate liquidity shocks are modelled as exogenous events. Extending our previous work (Cao & Illing, 2007), this paper analyses the adequate policy response to endogenous systemic liquidity risk. We analyse the feedback between lender of last resort policy and incentives of private banks, determining the aggregate amount of liquidity available. We show that imposing minimum liquidity standards for banks ex ante are a crucial requirement for sensible lender of last resort policy. In addition, we analyse the impact of equity requirements and narrow banking, in the sense that banks are required to hold sufficient liquid funds so as to pay out in all contingencies. We show that such a policy is strictly inferior to imposing minimum liquidity standards ex ante combined with lender of last resort policy.

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Paper provided by Center for Financial Studies (CFS) in its series CFS Working Paper Series with number 2008/23.

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Date of creation: 2008
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Handle: RePEc:zbw:cfswop:200823
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  1. Douglas W. Diamond & Raghuram G. Rajan, 2005. "Liquidity Shortages and Banking Crises," Journal of Finance, American Finance Association, vol. 60(2), pages 615-647, 04.
  2. Douglas W. Diamond & Raghuram G. Rajan, 1998. "Liquidity risk, liquidity creation and financial fragility: a theory of banking," Proceedings, Federal Reserve Bank of San Francisco, issue Sep.
  3. Bengt Holmstrom & Jean Tirole, 1996. "Private and Public Supply of Liquidity," NBER Working Papers 5817, National Bureau of Economic Research, Inc.
  4. Franklin Allen & Douglas Gale, 2003. "Financial Intermediaries and Markets," Center for Financial Institutions Working Papers 00-44, Wharton School Center for Financial Institutions, University of Pennsylvania.
  5. Jin Cao & Gerhard Illing, 2008. "Liquidity Shortages and Monetary Policy," CESifo Working Paper Series 2210, CESifo Group Munich.
  6. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 401-19, June.
  7. Rochet, Jean-Charles, 2004. "Macroeconomic shocks and banking supervision," Journal of Financial Stability, Elsevier, vol. 1(1), pages 93-110, September.
  8. Douglas W. Diamond & Raghuram G. Rajan, 2006. "Money in a Theory of Banking," American Economic Review, American Economic Association, vol. 96(1), pages 30-53, March.
  9. Franklin Allen & Douglas Gale, 1998. "Optimal Financial Crises," Journal of Finance, American Finance Association, vol. 53(4), pages 1245-1284, 08.
  10. Goodhart, Charles & Illing, Gerhard (ed.), 2002. "Financial Crises, Contagion, and the Lender of Last Resort: A Reader," OUP Catalogue, Oxford University Press, number 9780199247219, December.
  11. Oliver Hart & John Moore, 1994. "A Theory of Debt Based on the Inalienability of Human Capital," The Quarterly Journal of Economics, Oxford University Press, vol. 109(4), pages 841-879.
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