Illiquidity, insolvency, and banking regulation

Cao, Jin (February 2010): Illiquidity, insolvency, and banking regulation. Discussion Papers in Economics 2010-13

Abstract

This paper provides a compact framework for banking regulation analysis in the presence of uncertainty between systemic liquidity and solvency shocks. Extending the work by Cao & Illing (2009a, b), it is shown that systemic liquidity shortage arises endogenously as part of the inferior mixed strategy equilibrium. The paper compares dierent traditional regulatory policies which intend to fix the ineciencies, and argues that the co-existence of illiquidity and insolvency problems adds extra cost for banking regulation and makes some schemes that are optimal under pure illiquidity risks (such as liquidity regulation with lender of last resort policy) fail. The regulatory cost can be minimized by combining the advantages of several instruments.

• Item Type: Paper
• Form of publication: Preprint
• Keywords: liquidity risk, insolvency risk, liquidity regulation, equity requirement
• Faculties: Economics; Economics > Munich Discussion Papers in Economics; Economics > Munich Discussion Papers in Economics > Financial Markets; Economics > Munich Discussion Papers in Economics > Economic Policy; Economics > Munich Discussion Papers in Economics > Public Finance
• Subjects: 300 Social sciences > 300 Social sciences, sociology and anthropology; 300 Social sciences > 330 Economics
• JEL Classification: E5, G21, G28
• Language: English

References

Acharya, V. V. (2009): “A theory of systemic risk and design of prudential bank regulation”. Journal of Financial Stability, 5, 224–255.

Acharya, V. V. and T. Yorulmazer (2008): “Cash-in-the-market pricing and optimal resolution of bank failures”. Review of Financial Studies, 21, 2705–2742.

Allen, F., and D. Gale (1998): “Optimal financial crises”. Journal of Finance, 53, 1245–84.

Bolton, P., T. Santos and J. A. Scheinkman (2009a): “Outside and inside liquidity”. NBER Working paper 14867.

Bolton, P., T. Santos and J. A. Scheinkman (2009b): “Market and public liquidity”. American Economic Review, 99, 594–599.

Brunnermeier, M. K., and L. H. Pedersen (2009): “Market liquidity and funding liquidity”. Review of Financial Studies, 22, 2201–2238.

Cao, J. and G. Illing (2008): “Liquidity shortages and monetary policy”. CESifo Working Paper Series No. 2210, available at SSRN: http://ssrn.com/abstract=1090825.

Cao, J. and G. Illing (2009a): “Endogenous systemic liquidity risk”. CESifo Working Paper Series No. 2627, available at SSRN: http://ssrn.com/abstract=1393186.

Cao, J. and G. Illing (2009b): “Regulation of systemic liquidity risk”. Mimeo. University of Munich.

Diamond, D. W. and R. G. Rajan (2005): “Liquidity shortage and banking crises”. Journal of Finance, 60, 30–53.

Diamond, D. W. and R. G. Rajan (2006): “Money in the theory of banking”. American Economic Review, 60, 615–647.

Freixas, X., B. M. Parigi and J.-C. Rochet (2000): “Systemic risk, interbank relations, and liquidity provision by the central bank”. Journal of Money, Credit and Banking, 32, 611–638.

Freixas, X., B. M. Parigi and J.-C. Rochet (2004): “The lender of last re-sort: A twenty-first century approach”. Journal of the European Economic Association, 2, 1085–1115.

Gorton, G. (2007): “Banks, banking, and crises”. NBERReporter, 2007 Number 4, 11–14.

Gorton, G. (2009): “The subprime panic”. European Financial Management, 15, 10–46.

Gorton, G. and L. Huang (2004): “Liquidity, efficiency, and bank bailouts”. American Economic Review, 94, 455–483.

Holmstr ¨om, B. and J. Tirole (1998): “Private and public supply of liquidity”. Journal of Political Economy, 106, 1–40.

Holmström, B. and J. Tirole (2008): Wicksell lectures: Inside and outside liquidity. Mimeo. Toulouse School of Economics.

Korinek, A. (2008): “Systemic risk-taking: Accelerator effects, externalities, and regulatory responses”. Mimeo. University of Maryland.

Wagner, W. (2009): “Efficient asset allocations in the banking sector and financial regulation”. International Journal of Central Banking (forthcoming).