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Liquidity risk and financial stability regulation

Paul Pichler () and Flora Lutz ()
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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 pro t-maximizing banks always result in socially inecient outcomes, but the nature of ineciency depends critically on the structure of liquidity risk. Overborrowing and overinvestment in risky assets arises only if idiosyncratic risk is suciently small. By contrast, if idiosyncratic risk is large, unregulated banks underborrow, underinvest and hold insucient liquidity reserves. A macroprudential regulator can restore constrained eciency 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)
New Economics Papers: this item is included in nep-ban, nep-cba, nep-mac and nep-rmg
Date: 2017-04
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Handle: RePEc:vie:viennp:1701