Illiquidity, Insolvency, and Banking Regulation

40 Pages Posted: 22 Apr 2013

See all articles by Jin Cao

Jin Cao

Norges Bank - Research Department; CESifo (Center for Economic Studies and Ifo Institute)

Date Written: December 31, 2011


This paper provides a compact framework for banking regulation analysis in the presence of uncertainty between systemic liquidity and solvency shocks. It explains the asset price anomalies and bank lending freeze during the crisis. The paper shows how the coexistence of illiquidity and insolvency problems adds extra cost for banking regulation, making conventional regulatory policies fail, and why the unconventional central bank policy encourages moral hazard. A banking tax is proposed to cover the extra regulatory cost, and the regulatory cost can also be reduced by combining the advantages of several instruments.

Keywords: Liquidity risk, Insolvency risk, Liquidity regulation, Equity requirement, Banking tax

JEL Classification: E5, G21, G28

Suggested Citation

Cao, Jin, Illiquidity, Insolvency, and Banking Regulation (December 31, 2011). Norges Bank Working Paper 13, Available at SSRN: or

Jin Cao (Contact Author)

Norges Bank - Research Department ( email )

P.O. Box 1179
Oslo, N-0107

CESifo (Center for Economic Studies and Ifo Institute) ( email )

Poschinger Str. 5
Munich, DE-81679

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