Working Paper: NBER ID: w21880
Authors: Kinda Cheryl Hachem; Zheng Michael Song
Abstract: This paper shows that liquidity regulation can trigger unintended credit booms in the presence of interbank market power. We consider a price-setter and a continuum of price-takers who trade reserves after the realization of idiosyncratic liquidity shocks. The price-takers are endogenously less liquid and circumvent regulation by engaging in shadow banking, which leads to a reallocation of funding away from the more liquid price-setter. This reallocation channel underlies the credit boom. Endogenous responses in bank liquidity ratios also affect the magnitude of the boom. We discuss extensions of the model and illustrate its quantitative performance with an application to China.
Keywords: Liquidity regulation; Credit booms; Interbank market power; Shadow banking
JEL Codes: E44; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Liquidity regulation (G28) | Credit booms (E51) |
| Liquidity regulation (G28) | Liquidity ratios of banks (G21) |
| Liquidity ratios of banks (G21) | Magnitude of credit boom (E51) |
| Liquidity regulation (G28) | Increased credit per unit of savings (E51) |
| Enforcement of loan-to-deposit caps (G28) | Increase in credit-to-savings ratio (E51) |
| Credit boom (F65) | Changes in average interbank rate (E43) |
| Credit boom (F65) | Convergence of on-balance-sheet liquidity ratios among banks (F65) |
| Interbank market power (E58) | Credit dynamics (G21) |