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LIQUIDITY REGULATION AND FINANCIAL STABILITY

Published online by Cambridge University Press:  22 November 2018

Yang Li
Yang Li*
Affiliation:
Nankai University
*
Address correspondence to: Yang Li, Room 562 School of Finance, Nankai University, 38 Tongyan Road, Jinnan District, Tianjin, China, 300350; e-mail: yang.li@nankai.edu.cn. Phone: (+86)13810177850.
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Abstract

Anticipating a bailout in the event of a crisis distorts financial intermediaries’ incentives in multiple dimensions. Bailout payments can, for example, lead intermediaries to issue too much short-term debt while simultaneously underinvesting in liquid assets. To correct these distortions, policymakers may choose to regulate the composition of both the assets and liabilities of intermediaries. I examine these regulations in a version of the Diamond and Dybvig [(1983). Bank runs, deposit insurance, and liquidity. Journal of Political Economy, 91(3), 401–419] model with limited commitment. I demonstrate that, contrary to common wisdom, introducing a minimum liquidity requirement can increase intermediaries’ susceptibility to a run by their investors.

Keywords

BailoutsLiquidation CostMacroprudential PolicyTime-Inconsistency
Type
Articles
Information
Macroeconomic Dynamics , Volume 24 , Issue 5 , July 2020 , pp. 1240 - 1263
Copyright
© Cambridge University Press 2018

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Footnotes

I thank Oriol Carbonell-Nicolau, John Landon-Lane, Hyeon Ok Lee, Yuliyan Mitkov, Byoung Hark Yoo, and the anonymous reviewer for their suggestions. I am especially grateful to Todd Keister for numerous conversations and helpful guidance. All errors remain my own.

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