Liquidity risk and financial stability regulation

Paul Pichler () and Flora Lutz ()
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Paul Pichler: https://econ.univie.ac.at
Flora Lutz: https://econ.univie.ac.at

Vienna Economics Papers from University of Vienna, Department of Economics

Abstract: We study banks' borrowing and investment decisions in an economy with pecuniary externalities and both aggregate and idiosyncratic liquidity risk. We show that private decisions by profit-maximizing banks always result in socially inefficient outcomes, but the nature of inefficiency depends critically on the structure of liquidity risk. Overborrowing and overinvestment in risky assets arises only if idiosyncratic risk is sufficiently small. By contrast, if idiosyncratic risk is large, unregulated banks underborrow, underinvest and hold insufficient liquidity reserves. A macroprudential regulator can restore constrained efficiency by imposing countercyclical reserve requirements. Pigouvian taxes or bank capital requirements cannot achieve this objective.

JEL-codes: E44 E58 G21 G28 (search for similar items in EconPapers)
Date: 2017-04
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Citations: View citations in EconPapers (4)

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