New theory: Liquidity rules need bank size limits for efficiency

A new European Central Bank working paper proposes a general equilibrium theory where bank liquidity requirements improve incentives but are insufficient for efficient financial intermediation. The study argues that additional policies, such as limits on bank size or subsidies for non-bank liquidity provision, are necessary to achieve optimal allocation.

Liquidity: A tool for prudent risk management

This paper offers a novel perspective on bank liquidity, arguing it primarily addresses incentive problems rather than solely acting as a buffer against funding shocks.

Banks, financing loans with deposits, face moral hazard in risk management; holding cash mitigates these incentives despite foregone investment returns.

Liquid assets are safe and their value is independent of loan management, thus increasing pledgable value to depositors and strengthening prudent risk management.

However, banks prefer low liquidity due to costs, leading to insufficient holdings and reliance on costly asset sales during stress.

Liquidity requirements therefore play a crucial role in limiting fire sales and improving internal bank incentives.

The banking sector's oversized footprint

The model highlights a critical interaction between leveraged banks and equity-financed non-bank investors, who provide ex-post liquidity by purchasing bank assets.

In an unregulated market, too many financial experts choose to operate banks rather than act as liquidity providers.

This leads to an inefficiently large banking sector and insufficient liquidity from non-bank investors during stress.

The decentralized equilibrium features excessive entry into leveraged intermediation, distorting the allocation of financial activity.

Correcting this requires not only liquidity regulation but also policies to limit bank size or subsidize non-bank liquidity provision.

Beyond Basel III's narrow view

This paper fundamentally challenges the traditional justification for liquidity regulation, such as Basel III's LCR, by reframing liquidity as an incentive mechanism for credit risk management.

It highlights a critical gap in current policy, suggesting that internal bank buffers alone are insufficient to correct systemic distortions in financial intermediation.

Its implications could reshape how regulators approach the overall structure and sectoral allocation of the financial system.