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Working Papers

September 2015, No. 15-12R

Optimal Liquidity Regulation With Shadow Banking (Revised November 2017)

Borys Grochulski and Yuzhe Zhang

We study the impact of shadow banking on optimal liquidity regulation in a Diamond-Dybvig maturity mismatch environment. A pecuniary externality arising out of the banks' access to private retrade renders competitive equilibrium inefficient. A tax on illiquid assets and a subsidy to the liquid asset similar to the payment of interest on reserves (IOR) constitute an optimal liquidity regulation policy in this economy. Shadow banking gives banks an outside option that allows them to escape regulation but also entails a cost. We derive two implications of shadow banking for optimal liquidity regulation policy. First, optimal policy must implement a macroprudential cap on illiquid asset prices that binds only when the return on illiquid assets is high. Second, optimal policy must implement a fire sale of illiquid assets when high demand for liquidity is anticipated. We show how these features can be implemented by adjusting the IOR rate and the illiquid-asset tax rate.

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