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Financial Markets and Portfolio Management

, Volume 24, Issue 1, pp 31–48 | Cite as

Regulation of systemic liquidity risk

  • Jin CaoEmail author
  • Gerhard Illing
Article

Abstract

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.

Keywords

Liquidity regulation Systemic risk Lender of last resort Deposit insurance Financial stability 

JEL Classification

E5 G21 G28 

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Copyright information

© Swiss Society for Financial Market Research 2010

Authors and Affiliations

  1. 1.Department of EconomicsUniversity of MunichMunichGermany
  2. 2.Munich Graduate School of Economics (MGSE)MunichGermany
  3. 3.CESifoMunichGermany

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