Financial Stability Regulation under Borrowing and Liquidity Externalities

We study nancial stability regulation in an environment with pecuniary externalities and where banks face both a liability choice (between private money creation and long-term borrowing) and an asset choice (between liquid and illiquid investments). Return risk on illiquid assets gives rise to liquidity risk, because banks that learn to have low future returns nd themselves unable to roll over ‘money-like’ debt. Privately optimal borrowing and investment decisions by banks lead, in general, to socially inef cient outcomes. The nature of inef ciency depends critically on the degree to which liquidity risk is systemic: When risk is highly systemic, banks hold the socially optimal amount of liquid assets, but create an excessive amount of money and overinvest in risky assets; when risk is not highly systemic, banks hold too little liquidity, create insuf cient private money and underinvest in risky assets. Quantityand price-based regulations to address the identi ed inef ciencies are discussed. (JEL: E44, E58, G21, G28)