MPI Econ Workshop
March 29, 2017 - 14:00
Liquidity Creation, Capital Requirements and Regulatory Arbitrage (joint with Stephan Luck)
We present a model in which bank can create liquid claims by issuing equity as well as by relying on sales of risky assets in downturns, i.e., market-based liquidity creation. In the constrained-efficient allocation, liquidity creation partially relies on market-based liquidity creation, which necessarily induces fire sales in downturns. However, the inability of banks to contract future financing terms gives rise to a pecuniary externality, and there is a tendency for leverage to be excessive. In equilibrium, each single bank relies too much on market-based liquidity creation and fire sale effects are too strong. A natural way to address the pecuniary externality is to impose a uniform capital requirement, which acts like a tax on short-term debt. However, if regulatory arbitrage is possible, the inefficiency re-emerges: while regulated banks are not excessively leveraged, a shadow banking sector emerges and grows too large, inducing excessively high costs of fire sales. We argue that if regulatory arbitrage cannot be addressed directly, capital requirements need to be complemented by a Pigouvian subsidy for bank equity.
April 19, 2017 - 14:00
University of Innsbruck, Department of Economics
April 26, 2017 - 14:00
University of Bologna