Liquidity risk and financial stability regulation

Flora Lutz, Paul Pichler

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.

Department of Economics
No. of pages
Publication date
Austrian Fields of Science 2012
502053 Economics, 502027 Political economy
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