Regulation of Systemic Liquidity Risk

Cao, Jin and Illing, Gerhard (January 2010): Regulation of Systemic Liquidity Risk. Discussion Papers in Economics 2010-1

Abstract

The 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 as a result of limited liability. The paper compares different regulatory mechanisms to cope with the externalities. It is shown that the combination of liquidity regulation ex ante and lender of last resort policy ex post is able to implement the outcome maximizing investor’s payoff. In contrast, both “narrow banking” and imposing equity requirements as buffer are inferior mechanisms for coping with systemic liquidity risk.

• Item Type: Paper
• Form of publication: Preprint
• Keywords: Liquidity Regulation, Systemic risk, Lender of last resort, Financial Stability
• Faculties: Economics; Economics > Munich Discussion Papers in Economics; Economics > Munich Discussion Papers in Economics > Financial Markets; Economics > Munich Discussion Papers in Economics > Public Finance; Economics > Chairs > Seminar for Macroeconomics
• Subjects: 300 Social sciences > 300 Social sciences, sociology and anthropology; 300 Social sciences > 330 Economics
• JEL Classification: E5, G21, G28
• Language: English

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