Macroprudential Policy and Asset Liquidity

Abstract

This paper develops a dynamic model to study optimal liquidity regulations for multiple assets that differ in liquidity. I show that optimal macroprudential policies are affected by asset liquidity and the multi-asset structure. Lower asset liquidity amplifies declines in asset prices and tightens the collateral constraint during financial crises, raising macroprudential taxes on debt. With multiple assets, the marginal benefit of investing in one asset is affected by cross-price elasticities of all assets, depending on trading positions and the collateral constraint's tightness. The optimal policy in the multi-asset model can differ from those in standard one-asset models in size and sign. Quantitatively, optimal macroprudential policies favor liquid assets and reduce borrowing. The policy reduces the probability of financial crises from 8% to zero and increases welfare by 1.2%. Finally, I analyze and quantify the current Basel III reform, which increases agents' liquid holdings and decreases the probability of crises. However, the policy reduces welfare, as agents overborrow and overinvest in liquid assets.

Keywords: Financial crises; Macroprudential policy; Liquidity; Fire sale; Basel III.

JEL Classification: D62, E32, E44, G01, G23, G28.