The Return of Liquidity Regulation - An Inquiry into Liquidity Regulation as a Prudential Policy Tool

Abstract

The financial crisis of 2007-08 highlighted the vulnerability of the financial system to a liquidity shock. Uninsured creditors ran on banks after observing a significant credit shock. Unable to meet its obligations to pay these creditors, banks were forced to sell illiquid assets at a large discount to raise cash quickly. As clarified by Shleifer and Vishny (2011), the forced sale of assets is known as a fire sale, and it can lead to financial instability that will have consequences for the real economy. This thesis seeks to understand how, and to what extent, liquidity regulation should be used as a prudential policy tool against selected effects of a liquidity shock. First, I seek a rationale for implementing liquidity regulation. I use a model by Kara and Ozsoy (2016) to argue that exposure to a fire-sale event is optimal. Liquidity regulation should attempt to mitigate the exposure, since banks’ exposure is excessive in an unregulated equilibrium compared to social optimum. I then use the model as a focal point for further discussion and propose other reasons for excessive exposure to fire sales. I then propose a backup plan if liquidity regulation is inadequate to prevent a systemwide disruption. Following Carlson et al. (2015), I argue for the necessity of a LOLR to intervene ex post. In that case, a practical benefit of liquidity regulation is that it buys time for a LOLR to examine the situation, and devise an appropriate response.