The Dark Side of Liquidity Creation: Leverage and Systemic Risk

60 Pages Posted: 18 Dec 2014 Last revised: 21 Jan 2016

Viral V. Acharya

New York University - Leonard N. Stern School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); New York University (NYU) - Department of Finance

Anjan V. Thakor

Washington University, Saint Louis - John M. Olin School of Business; European Corporate Governance Institute (ECGI)

Date Written: December 2, 2015

Abstract

We consider a model in which the threat of bank liquidations by creditors as well as equity-based compensation incentives both discipline bankers, but with different consequences. Greater use of equity leads to lower ex ante bank liquidity, whereas greater use of debt leads to a higher probability of inefficient bank liquidation. The bank’s privately-optimal capital structure trades off these two costs. With uncertainty about aggregate risk, bank creditors learn from other banks’ liquidation decisions. Such inference can lead to contagious liquidations, some of which are inefficient; this is a negative externality that is ignored in privately-optimal bank capital structures. Thus, under plausible conditions, banks choose excessive leverage relative to the socially optimal level, providing a rationale for bank capital regulation. While a blanket regulatory forbearance policy can eliminate contagion, it also eliminates all market discipline. However, a regulator generating its own information about aggregate risk, rather than relying on market signals, can restore efficiency by intervening selectively.

Keywords: micro-prudential regulation, macroprudential regulation, market discipline, contagion, lender of last resort, bailouts, capital requirements

JEL Classification: G21, G28, G32, G35, G38

Suggested Citation

Acharya, Viral V. and Thakor, Anjan V., The Dark Side of Liquidity Creation: Leverage and Systemic Risk (December 2, 2015). Journal of Financial Intermediation, Forthcoming; European Corporate Governance Institute (ECGI) - Finance Working Paper No. 445/2015. Available at SSRN: https://ssrn.com/abstract=2539334 or http://dx.doi.org/10.2139/ssrn.2539334

Viral V. Acharya

New York University - Leonard N. Stern School of Business ( email )

44 West 4th Street
New York, NY NY 10012
United States

HOME PAGE: http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/~vacharya.htm

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

New York University (NYU) - Department of Finance

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

Anjan V. Thakor (Contact Author)

Washington University, Saint Louis - John M. Olin School of Business ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

European Corporate Governance Institute (ECGI) ( email )

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

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