How Liquidity Regulations Affect Bank Complexity: GFC vs COVID-19 Crisis
81 Pages Posted: 25 Jun 2020
Date Written: June 1, 2020
We introduce a calibrated general equilibrium model to illustrate the effect of liquidity regulations on banks' investment in complex assets and the implications for financial stability policies. Complexity, which is a form of opacity, improves bank liquidity in good times, but it also heightens vulnerability to runs during crises. Liquidity regulations support interbank lending markets during crises, but this effect is attenuated since it also encourages banks to invest in complex assets. When calibrating the model to the global financial crisis (GFC), the stabilizing benefits of liquidity regulations during crises do not compensate for the costs associated with requiring banks to hold low-return liquid assets. We consider a set of alternative policies and show that an ex-ante insurance mechanism achieves a greater improvement in welfare compared to ex-post interventions that support interbank loan prices, such as quantitative easing (QE), or asset-specific taxes that target inefficiencies in the degree of investment in complex assets. Finally, we show that the model's predictions are consistent with empirical evidence showing that the Liquidity Coverage Ratio, a novel liquidity regulation that was implemented in the time between the GFC and the COVID-19 crisis, was associated with increased investment in complex assets like mortgage-backed securities (MBSs), higher interbank loan prices during crises, and an amplified effect of QE on MBS prices.
Keywords: liquidity regulation; bank complexity; repo market; crisis
JEL Classification: G01, G21, G28
Suggested Citation: Suggested Citation