DP13631 Inefficiency and Regulation of Private Liquidity

Author(s): Pierpaolo Benigno, Roberto Robatto
Publication Date: March 2019
Date Revised: March 2019
Programme Areas: Financial Economics, Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=13631

We propose a simple model to study the efficiency of liquidity creation by financial intermediaries, which can take the form of either safe or risky debt. Liquidity crises arise when risky debt is defaulted on and stops providing liquidity services. Owing to a novel externality related to liquidity premia and the cost of issuing safe debt, the laissez-faire equilibrium is inefficient, characterized by an excessive supply of risky debt. However, the optimal policy requires the regulation of safe debt as well. Capital requirements targeting risky debt alone have unintended welfare-reducing consequences.