Working Paper: CEPR ID: DP8271
Authors: Enrico C. Perotti; Javier Suarez
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 Codes: G21; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Pigovian tax on short-term funding (H23) | containment of risk (G22) |
| Pigovian tax on short-term funding (H29) | preservation of credit quality (G33) |
| quantity-based funding ratios (I22) | distortion in liquidity (E41) |
| liquidity buffers (E41) | deadweight costs (J32) |
| excess credit incentives (H81) | ineffectiveness of liquidity buffers (G33) |
| gambling incentives due to low charter value or overconfidence (H27) | excess credit and liquidity risk (E51) |
| net funding ratios (G32) | control of excess credit and liquidity risk (E51) |
| taxes on short-term funding (F38) | efficiency in managing risk-shifting incentives (D61) |
| optimal policy (C61) | incorporation of both types of tools (C88) |