Endogenous Exposure to Systemic Liquidity Risk

Traditionally aggregate liquidity shocks are modeled as exogenous events. This paper analyzes the adequate policy response to endogenous exposure to systemic liquidity risk. We analyze the feedback between lender-of-last-resort policy and incentives of private banks determining the aggregate amount of liquidity available. We show that imposing minimum liquidity standards for banks ex ante is a crucial requirement for sensible lender-of-last-resort policy. In addition we analyze the impact of equity requirements and narrow banking in the sense that banks are required to hold sufficient liquid funds so as to pay out in all contingencies. We show that both policies are strictly inferior to imposing minimum liquidity standards ex ante combined with lender-of-last-resort policy.