Regulation of systemic liquidity risk

Jin Cao () and Gerhard Illing

Munich Reprints in Economics from University of Munich, Department of Economics

Abstract: This 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 due to their limited liability. The paper compares different regulatory mechanisms to cope with the externalities. We show that a combination of liquidity regulation ex ante and lender of last resort policy ex post can maximize investor payoff. In contrast, both \"narrow banking\" and imposing equity requirements as a buffer are inferior mechanisms for coping with systemic liquidity risk.

Date: 2010
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Citations: View citations in EconPapers (10)

Published in Financial Markets and Portfolio Management 1 24(2010): pp. 31-48

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Journal Article: Regulation of systemic liquidity risk (2010)
Working Paper: Regulation of Systemic Liquidity Risk (2010)
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