Regulation of Systemic Liquidity Risk

Jin Cao () and Gerhard Illing

Discussion Papers in Economics from University of Munich, Department of Economics

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.

Keywords: Liquidity Regulation; Systemic risk; Lender of last resort; Financial Stability (search for similar items in EconPapers)
JEL-codes: E5 G21 G28 (search for similar items in EconPapers)
Date: 2010-01
New Economics Papers: this item is included in nep-ban, nep-bec, nep-mac, nep-reg and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (10)

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Related works:
Journal Article: Regulation of systemic liquidity risk (2010)
Working Paper: Regulation of systemic liquidity risk (2010)
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Persistent link: https://EconPapers.repec.org/RePEc:lmu:muenec:11306

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