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Optimal liquidity policy with shadow banking

  • Borys GrochulskiEmail author
  • Yuzhe Zhang
Research Article
  • 285 Downloads

Abstract

We study the impact of shadow banking on optimal liquidity regulation in a Diamond–Dybvig maturity-mismatch environment. In this economy, a pecuniary externality arising out of the banks’ access to private retrade renders competitive equilibrium inefficient. A tax on illiquid assets and a subsidy to the liquid asset similar to the payment of interest on reserves (IOR) constitute an optimal liquidity regulation policy. Shadow banking gives banks an outside option allowing them to escape regulation at the cost of forgoing access to the government safety net. We derive two implications of shadow banking for optimal liquidity regulation policy. First, optimal policy must implement a macroprudential cap on illiquid-asset prices that binds only when the return on illiquid assets is high. Second, optimal policy must implement a fire sale of illiquid assets when high demand for liquidity is anticipated. We show how these features can be implemented by adjusting the IOR rate and the illiquid-asset tax rate.

Keywords

Maturity mismatch Shadow banking Mechanism design Pecuniary externality Private retrade Liquidity regulation Interest on reserves Illiquid-asset tax 

JEL Classification

G21 G23 E58 

Notes

Acknowledgements

The authors are grateful to Javier Bianchi, Dean Corbae, Douglas Diamond, Huberto Ennis, Alan Moreira, Guillaume Plantin, Kieran Walsh, Russell Wong, Nicholas Yannelis, Ariel Zetlin-Jones, and an anonymous referee for their helpful comments. A working-paper version of this article was circulated under the title “Optimal liquidity regulation with shadow banking.” The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Richmond or the Federal Reserve System.

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Copyright information

© Springer-Verlag GmbH Germany, part of Springer Nature 2018

Authors and Affiliations

  1. 1.Research DepartmentFederal Reserve Bank of RichmondRichmondUSA
  2. 2.Department of EconomicsTexas A&M UniversityCollege StationUSA

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