A Pigovian Approach to Liquidity Regulation

Enrico Perotti and Javier Suarez

No 8271, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: This paper discusses liquidity regulation when short-term funding enables credit growth but generates negative systemic risk externalities. It focuses on the relative merit of price versus quantity rules, showing how they target different incentives for risk creation. When banks differ in credit opportunities, a Pigovian tax on short-term funding is efficient in containing risk and preserving credit quality, while quantity-based funding ratios are distorsionary. Liquidity buffers are either fully ineffective or similar to a Pigovian tax with deadweight costs. Critically, they may be least binding when excess credit incentives are strongest. When banks differ instead mostly in gambling incentives (due to low charter value or overconfidence), excess credit and liquidity risk are best controlled with net funding ratios. Taxes on short-term funding emerge again as efficient when capital or liquidity ratios keep risk shifting incentives under control. In general, an optimal policy should involve both types of tools.

Keywords: Liquidity requirements; Liquidity risk; Liquidity risk levies; Macroprudential regulation; Systemic risk (search for similar items in EconPapers)
JEL-codes: G21 G28 (search for similar items in EconPapers)
Date: 2011-02
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Citations: View citations in EconPapers (146)

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Related works:
Journal Article: A Pigovian Approach to Liquidity Regulation (2011)
Working Paper: A Pigovian Approach to Liquidity Regulation (2011)
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