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.
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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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