Philipp König, David Pothier
This paper studies the following questions related to the liquidity regulation of banks and financial intermediaries. (a) Under which circumstances does liquidity underinsurance occur,so that liquidity regulation is necessarily required? (b) Is regulation the most efficient way to mitigate underinsurance? (c) How does liquidity regulation interact with other regulatory measures and the liquidity provision from the central bank? To study these questions, we develop a global game model of banking in the presence of illiquidity risk. An innovation of our model is that it explicitly takes into account ex ante effects of liquidity risk and regulation on banks' portfolio choices. We establish three results: 1) When markets internalize liquidity risk, banks self-insure. However, 2) this leads to socially inefficient asset allocations. We also show that 3) markets may fail to internalize liquidity risk due to balance sheet opacity. In this case, regulation may be useful.
JEL-Classification: G01;G21;G28
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