Inefficient Liquidity Creation
49 Pages Posted: 7 Feb 2018 Last revised: 16 Jun 2021
Date Written: April 4, 2019
We present a model in which intermediaries create liquidity by issuing safe debt. Two types of intermediaries emerge: Traditional banks that create liquidity by issuing equity and holding assets to maturity, and market-based intermediaries that create liquidity by selling assets in fire sales in downturns. We show that the reliance on market-based intermediation is necessarily too high, but liquidity creation is not. It can also be too low as the endogenous fire-sale risk can push liquidity creation below its optimum. We argue that standard capital or liquidity regulation are ineffective, and optimal macroprudential regulation should instead target market-based intermediation.
Keywords: banking; macroprudential regulation; liquidity creation; fire sales; pecuniary externalities; shadow banking; regulatory arbitrage
JEL Classification: G01, G21, G23, G28
Suggested Citation: Suggested Citation