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Regulation of systemic liquidity risk

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  • Cao, Jin
  • Illing, Gerhard

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.

Suggested Citation

  • Cao, Jin & Illing, Gerhard, 2010. "Regulation of systemic liquidity risk," Munich Reprints in Economics 19999, University of Munich, Department of Economics.
    • Handle: RePEc:lmu:muenar:19999
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    References listed on IDEAS

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    2. 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.
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    4. Cao, Jin & Illing, Gerhard, 2008. "Endogenous Systemic Liquidity Risk," Discussion Papers in Economics 3358, University of Munich, Department of Economics.
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    13. Gersbach, Hans, 2009. "Private Insurance Against Systemic Crises?," CEPR Discussion Papers 7342, C.E.P.R. Discussion Papers.
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    Citations

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    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. Roberts, Daniel & Sarkar, Asani & Shachar, Or, 2023. "Liquidity regulations, bank lending and fire-sale risk," Journal of Banking & Finance, Elsevier, vol. 156(C).
    3. 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.
    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. Bonfim, D. & Kim, M., 2012. "Liquidity Risk in Banking : Is there Herding?," Other publications TiSEM 6e6df5ea-401b-49a2-b1be-4, Tilburg University, School of Economics and Management.
    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.

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    More about this item

    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

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