Working Paper: CEPR ID: DP13631
Authors: Pierpaolo Benigno; Roberto Robatto
Abstract: 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.
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Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| private intermediaries' creation of liquidity (D40) | inefficiencies in private liquidity creation (E44) |
| supply of risky debt (G21) | increased liquidity premia (E41) |
| increased liquidity premia (E41) | raising borrowing costs for safe debt issuers (H74) |
| laissez-faire equilibrium (D50) | overproduction of risky liquidity (E44) |
| eliminating risky liquidity alone (G33) | void filled by more costly safe assets (G19) |
| void filled by more costly safe assets (G19) | excessive social costs (D62) |
| optimal regulation must encompass both risky and safe liquidity (G18) | overall efficiency of the financial system (G20) |
| capital requirements targeting only risky debt (G21) | unintended welfare-reducing consequences (D69) |