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Liquidity risk and financial stability regulation

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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 profit-maximizing banks always result in socially inefficient outcomes, but the nature of inefficiency depends critically on the structure of liquidity risk. Overborrowing and overinvestment in risky assets arises only if idiosyncratic risk is sufficiently small. By contrast, if idiosyncratic risk is large, unregulated banks underborrow, underinvest and hold insufficient liquidity reserves. A macroprudential regulator can restore constrained efficiency by imposing countercyclical reserve requirements. Pigouvian taxes or bank capital requirements cannot achieve this objective.

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  • Paul Pichler & Flora Lutz, 2017. "Liquidity risk and financial stability regulation," Vienna Economics Papers vie1701, University of Vienna, Department of Economics.
    • Handle: RePEc:vie:viennp:vie1701
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    Cited by:

    1. Flora Lutz & Leopold Zessner-Spitzenberg, 2019. "Sudden Stops and Reserve Accumulation in the Presence of International Liquidity Risk," Vienna Economics Papers 1907, University of Vienna, Department of Economics.
    2. Flora Lutz & Leopold Zessner-Spitzenberg, 2019. "Sudden Stops and Reserve Accumulation in the Presence of International Liquidity Risk," Vienna Economics Papers vie1907, University of Vienna, Department of Economics.
    3. Glocker, Christian, 2019. "Do reserve requirements reduce the risk of bank failure?," MPRA Paper 95634, University Library of Munich, Germany.
    4. Lutz, Flora & Zessner-Spitzenberg, Leopold, 2020. "Sudden Stops and Reserve Accumulation in the Presence of International Liquidity Risk," VfS Annual Conference 2020 (Virtual Conference): Gender Economics 224520, Verein für Socialpolitik / German Economic Association.

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    More about this item

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • 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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