A Pigovian Approach to Liquidity Regulation

32 Pages Posted: 14 Mar 2011

See all articles by Enrico C. Perotti

Enrico C. Perotti

University of Amsterdam - Finance Group; Centre for Economic Policy Research (CEPR)

Javier Suarez

Centre for Monetary and Financial Studies (CEMFI); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Multiple version iconThere are 2 versions of this paper

Date Written: March 2011

Abstract

This paper discusses liquidity regulation when short-term funding enables credit growth but generates negative systemic risk externalities. It focuses on the relative merit of price versus quantity rules, showing how they target different incentives for risk creation. When banks differ in credit opportunities, a Pigovian tax on short-term funding is efficient in containing risk and preserving credit quality, while quantity-based funding ratios are distorsionary. Liquidity buffers are either fully ineffective or similar to a Pigovian tax with deadweight costs. Critically, they may be least binding when excess credit incentives are strongest. When banks differ instead mostly in gambling incentives (due to low charter value or overconfidence), excess credit and liquidity risk are best controlled with net funding ratios. Taxes on short-term funding emerge again as efficient when capital or liquidity ratios keep risk shifting incentives under control. In general, an optimal policy should involve both types of tools.

Keywords: Liquidity requirements, Liquidity risk, Liquidity risk levies, Macroprudential regulation, Systemic risk

JEL Classification: G21, G28

Suggested Citation

Perotti, Enrico C. and Suarez, Javier, A Pigovian Approach to Liquidity Regulation (March 2011). CEPR Discussion Paper No. DP8271, Available at SSRN: https://ssrn.com/abstract=1782565

Enrico C. Perotti (Contact Author)

University of Amsterdam - Finance Group ( email )

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HOME PAGE: http://www.fee.uva.nl/fm/people/pero.htm

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Javier Suarez

Centre for Monetary and Financial Studies (CEMFI) ( email )

Casado del Alisal 5
28014 Madrid
Spain
+34 91 429 0551 (Phone)
+34 91 429 1056 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

European Corporate Governance Institute (ECGI)

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

HOME PAGE: http://www.ecgi.org

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