Inefficiency and Regulation of Private Liquidity
56 Pages Posted: 25 Apr 2019 Last revised: 27 Aug 2019
Date Written: August 23, 2019
We propose a simple model to study the efficiency of private liquidity creation by financial intermediaries. Liquidity is provided by both safe and risky debt, and liquidity crises arise when risky debt is defaulted on and stops providing liquidity services. Because of a novel externality related to liquidity premia and the cost of issuing safe debt, the equilibrium is inefficient and characterized by an excessive supply of risky debt. However, the optimal regulation requires that not only risky but also safe debt be targeted, and regulating risky debt alone has unintended welfare-reducing consequences.
Keywords: Private liquidity creation, safe assets, risky liquidity, procyclical financial regulation, capital requirements
JEL Classification: G01, G20, E44
Suggested Citation: Suggested Citation