Regulation of systemic liquidity risk
- 307 Downloads
This paper provides a baseline model for regulatory analysis of systemic liquidity shocks. We show that banks may have an incentive to invest excessively in illiquid long-term projects. In the prevailing mixed-strategy equilibrium, the allocation is inferior from the investor’s point of view since some banks free ride on the liquidity provision due to their limited liability. The paper compares different regulatory mechanisms to cope with the externalities. We show that a combination of liquidity regulation ex ante and lender of last resort policy ex post can maximize investor payoff. In contrast, both “narrow banking” and imposing equity requirements as a buffer are inferior mechanisms for coping with systemic liquidity risk.
KeywordsLiquidity regulation Systemic risk Lender of last resort Deposit insurance Financial stability
JEL ClassificationE5 G21 G28
Unable to display preview. Download preview PDF.
- Acharya, V.V., Yorulmazer, T.: Limited liability and bank herding. Mimeo, London Business School (2005) Google Scholar
- Cao, J., Illing, G.: Liquidity shortages and monetary policy. CESifo Working Paper Series No. 2210, available at SSRN: http://ssrn.com/abstract=1090825 (2008)
- Cao, J., Illing, G.: Endogenous systemic liquidity risk. CESifo Working Paper Series No. 2627, available at SSRN: http://ssrn.com/abstract=1191722 (2009)
- Danielsson, J., Embrechts, P., Goodhart, C., Keating, C., Muennich, F., Renault, O., Shin, H.: An academic response to Basel II. LSE Financial Markets Group Special Paper No. 130 (2001) Google Scholar
- Gersbach, H.: Private Insurance against systemic crises? CEPR Discussion Paper No. 7342, London (2009) Google Scholar
- Kashyap, A., Rajan, R., Stein, J.: Rethinking capital regulation. In: Symposium on “maintaining stability in a changing financial system”, Jackson Hole (2008) Google Scholar
- Korinek, A.: Systemic risk-taking: Accelerator effects, externalities, and regulatory responses. Mimeo, University of Maryland (2008) Google Scholar
- Wagner, W.: Efficient asset allocations in the banking sector and financial regulation. Int. J. Centr. Bank. 5(1), 75–95 (2009) Google Scholar
- Wilson, L., Wu, Y.W.: Common (stock) sense about risk-shifting and bank bailouts. Financ. Mark. Portf. Manag. 24 (2010) Google Scholar