IDEAS home Printed from https://ideas.repec.org/a/kap/fmktpm/v24y2010i1p31-48.html
   My bibliography  Save this article

Regulation of systemic liquidity risk

Author

Listed:
  • Jin Cao
  • Gerhard Illing

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. Copyright Swiss Society for Financial Market Research 2010

Suggested Citation

  • Jin Cao & Gerhard Illing, 2010. "Regulation of systemic liquidity risk," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 24(1), pages 31-48, March.
    • Handle: RePEc:kap:fmktpm:v:24:y:2010:i:1:p:31-48
    DOI: 10.1007/s11408-009-0126-x
    as

    Download full text from publisher

    File URL: http://hdl.handle.net/10.1007/s11408-009-0126-x
    Download Restriction: Access to full text is restricted to subscribers.
    File URL: https://libkey.io/10.1007/s11408-009-0126-x?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to look for a different version below or search for a different version of it.

    Other versions of this item:

    References listed on IDEAS

    as
    1. Acharya, Viral V., 2009. "A theory of systemic risk and design of prudential bank regulation," Journal of Financial Stability, Elsevier, vol. 5(3), pages 224-255, September.
    2. Bengt Holmstrom & Jean Tirole, 1998. "Private and Public Supply of Liquidity," Journal of Political Economy, University of Chicago Press, vol. 106(1), pages 1-40, February.
    3. Douglas W. Diamond & Raghuram G. Rajan, 2006. "Money in a Theory of Banking," American Economic Review, American Economic Association, vol. 96(1), pages 30-53, March.
    4. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, vol. 24(Win), pages 14-23.
    5. Douglas W. Diamond & Raghuram G. Rajan, 2001. "Liquidity Risk, Liquidity Creation, and Financial Fragility: A Theory of Banking," Journal of Political Economy, University of Chicago Press, vol. 109(2), pages 287-327, April.
    6. Oliver Hart & John Moore, 1994. "A Theory of Debt Based on the Inalienability of Human Capital," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 109(4), pages 841-879.
    7. Claudio Borio, 2003. "Towards a Macroprudential Framework for Financial Supervision and Regulation?," CESifo Economic Studies, CESifo Group, vol. 49(2), pages 181-215.
    8. Cao, Jin & Illing, Gerhard, 2008. "Endogenous Systemic Liquidity Risk," Discussion Papers in Economics 3358, University of Munich, Department of Economics.
    9. Wolf Wagner, 2009. "Efficient Asset Allocations in the Banking Sector and Financial Regulation," International Journal of Central Banking, International Journal of Central Banking, vol. 5(1), pages 75-95, March.
    10. Franklin Allen & Douglas Gale, 2005. "From Cash-in-the-Market Pricing to Financial Fragility," Journal of the European Economic Association, MIT Press, vol. 3(2-3), pages 535-546, 04/05.
    11. Illing, Gerhard & Cao, Jin, 2007. "Liquidity Shortages and Monetary Policy," Discussion Papers in Economics 2008, University of Munich, Department of Economics.
    12. repec:bla:jfinan:v:53:y:1998:i:4:p:1245-1284 is not listed on IDEAS
    13. Gersbach, Hans, 2009. "Private Insurance Against Systemic Crises?," CEPR Discussion Papers 7342, C.E.P.R. Discussion Papers.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Adrian, Tobias & Boyarchenko, Nina, 2018. "Liquidity policies and systemic risk," Journal of Financial Intermediation, Elsevier, vol. 35(PB), pages 45-60.
    2. Diana Bonfim & Moshe Kim, 2012. "Systemic Liquidity Risk," Economic Bulletin and Financial Stability Report Articles and Banco de Portugal Economic Studies, Banco de Portugal, Economics and Research Department.
    3. Roberts, Daniel & Sarkar, Asani & Shachar, Or, 2023. "Liquidity regulations, bank lending and fire-sale risk," Journal of Banking & Finance, Elsevier, vol. 156(C).
    4. Ellis, Scott & Sharma, Satish & Brzeszczyński, Janusz, 2022. "Systemic risk measures and regulatory challenges," Journal of Financial Stability, Elsevier, vol. 61(C).
    5. de la Torre, Augusto & Ize, Alain, 2013. "The foundations of macroprudential regulation : a conceptual roadmap," Policy Research Working Paper Series 6575, The World Bank.
    6. Diana Bonfim & Moshe Kim, 2012. "Liquidity risk in banking: is there herding?," Working Papers w201218, Banco de Portugal, Economics and Research Department.
    7. Silva, Walmir & Kimura, Herbert & Sobreiro, Vinicius Amorim, 2017. "An analysis of the literature on systemic financial risk: A survey," Journal of Financial Stability, Elsevier, vol. 28(C), pages 91-114.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Cao, Jin & Illing, Gerhard, 2008. "Endogenous Systemic Liquidity Risk," Discussion Papers in Economics 3358, University of Munich, Department of Economics.
    2. Douglas W. Diamond & Raghuram G. Rajan, 2005. "Liquidity Shortages and Banking Crises," Journal of Finance, American Finance Association, vol. 60(2), pages 615-647, April.
    3. Nikolaou, Kleopatra, 2009. "Liquidity (risk) concepts: definitions and interactions," Working Paper Series 1008, European Central Bank.
    4. Abbassi, Puriya & Iyer, Rajkamal & Peydró, José-Luis & Tous, Francesc R., 2016. "Securities trading by banks and credit supply: Micro-evidence from the crisis," Journal of Financial Economics, Elsevier, vol. 121(3), pages 569-594.
    5. Diamond, Douglas W. & Rajan, Raghuram G., 2001. "Banks, short-term debt and financial crises: theory, policy implications and applications," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 54(1), pages 37-71, June.
    6. Jin Cao & Gerhard Illing, 2022. "Money in the Equilibrium of Banking," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 54(1), pages 119-144, February.
    7. Brunnermeier, Markus K. & Oehmke, Martin, 2013. "Bubbles, Financial Crises, and Systemic Risk," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, volume 2, chapter 0, pages 1221-1288, Elsevier.
    8. Viral V. Acharya & Hyun Song Shin & Tanju Yorulmazer, 2011. "Crisis Resolution and Bank Liquidity," The Review of Financial Studies, Society for Financial Studies, vol. 24(6), pages 2166-2205.
    9. Dietrich, Diemo & Gehrig, Thomas, 2021. "Speculative and precautionary demand for liquidity in competitive banking markets," LSE Research Online Documents on Economics 118869, London School of Economics and Political Science, LSE Library.
    10. Dwyer Jr., Gerald P. & Samartín, Margarita, 2009. "Why do banks promise to pay par on demand?," Journal of Financial Stability, Elsevier, vol. 5(2), pages 147-169, June.
    11. Choi, Dong Beom & Eisenbach, Thomas M. & Yorulmazer, Tanju, 2021. "Watering a lemon tree: Heterogeneous risk taking and monetary policy transmission," Journal of Financial Intermediation, Elsevier, vol. 47(C).
    12. Viral V. Acharya & S. Viswanathan, 2011. "Leverage, Moral Hazard, and Liquidity," Journal of Finance, American Finance Association, vol. 66(1), pages 99-138, February.
    13. Silva, Walmir & Kimura, Herbert & Sobreiro, Vinicius Amorim, 2017. "An analysis of the literature on systemic financial risk: A survey," Journal of Financial Stability, Elsevier, vol. 28(C), pages 91-114.
    14. Iyer, Rajkamal & Peydró, José-Luis & Abbassi, Puriya & Tous, Francesc, 2015. "Securities Trading by Banks and Credit Supply: Micro-Evidence," CEPR Discussion Papers 10480, C.E.P.R. Discussion Papers.
    15. Kahn, Charles M. & Wagner, Wolf, 2021. "Sources of Liquidity and Liquidity Shortages," Journal of Financial Intermediation, Elsevier, vol. 46(C).
    16. Beck, Thorsten & Carletti, Elena & Goldstein, Itay, 2016. "Financial Regulation in Europe: Foundations and Challenges," CEPR Discussion Papers 11147, C.E.P.R. Discussion Papers.
    17. Douglas W. Diamond & Raghuram G. Rajan, 2012. "Illiquid Banks, Financial Stability, and Interest Rate Policy," Journal of Political Economy, University of Chicago Press, vol. 120(3), pages 552-591.
    18. Claudio Borio, 2011. "Rediscovering the Macroeconomic Roots of Financial Stability Policy: Journey, Challenges, and a Way Forward," Annual Review of Financial Economics, Annual Reviews, vol. 3(1), pages 87-117, December.
    19. Oliver D. Hart & Luigi Zingales, 2011. "Inefficient Provision of Liquidity," NBER Working Papers 17299, National Bureau of Economic Research, Inc.
    20. Rivero Leiva, David & Rodríguez Mendizábal, Hugo, 2019. "Self-fulfilling runs and endogenous liquidity creation," Journal of Financial Stability, Elsevier, vol. 45(C).

    More about this item

    Keywords

    Liquidity regulation; Systemic risk; Lender of last resort; Deposit insurance; Financial stability; E5; G21; G28;
    All these keywords.

    JEL classification:

    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:kap:fmktpm:v:24:y:2010:i:1:p:31-48. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Sonal Shukla or Springer Nature Abstracting and Indexing (email available below). General contact details of provider: http://www.springer.com .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.