Optimal liquidity policy with shadow banking

Borys Grochulski and Yuzhe Zhang ()
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Yuzhe Zhang: Texas A&M University

Economic Theory, 2019, vol. 68, issue 4, No 8, 967-1015

Abstract: Abstract We study the impact of shadow banking on optimal liquidity regulation in a Diamond–Dybvig maturity-mismatch environment. In this economy, a pecuniary externality arising out of the banks’ access to private retrade renders competitive equilibrium inefficient. A tax on illiquid assets and a subsidy to the liquid asset similar to the payment of interest on reserves (IOR) constitute an optimal liquidity regulation policy. Shadow banking gives banks an outside option allowing them to escape regulation at the cost of forgoing access to the government safety net. We derive two implications of shadow banking for optimal liquidity regulation policy. First, optimal policy must implement a macroprudential cap on illiquid-asset prices that binds only when the return on illiquid assets is high. Second, optimal policy must implement a fire sale of illiquid assets when high demand for liquidity is anticipated. We show how these features can be implemented by adjusting the IOR rate and the illiquid-asset tax rate.

Keywords: Maturity mismatch; Shadow banking; Mechanism design; Pecuniary externality; Private retrade; Liquidity regulation; Interest on reserves; Illiquid-asset tax (search for similar items in EconPapers)
JEL-codes: E58 G21 G23 (search for similar items in EconPapers)
Date: 2019
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Citations: View citations in EconPapers (3)

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DOI: 10.1007/s00199-018-1152-6

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