December 2011 issue contents
A Pigovian Approach to Liquidity Regulation

by Enrico Perottia and Javier Suarezb


This paper discusses liquidity regulation when short-term funding enables credit growth but generates negative systemic risk externalities. It focuses on the relative merit of price versus quantity rules, showing how they target different incentives for risk creation. When banks differ in credit opportunities, a Pigovian tax on short-term funding is efficient in containing risk and preserving credit quality, while quantity-based funding ratios are distortionary. Liquidity buffers are either fully ineffective or similar to a Pigovian tax with deadweight costs. Critically, they may be least binding when excess credit incentives are strongest. When banks differ instead mostly in gambling incentives (due to low charter value or overconfidence), excess credit and liquidity risk are best controlled with net funding ratios. Taxes on short-term funding emerge again as efficient when capital or liquidity ratios keep risk-shifting incentives under control. In general, an optimal policy should involve both types of tools.

JEL Codes: G21, G28.

Full article (PDF, 39 pages 382 kb)

Discussion by Ernst-Ludwig von Thadden

a University of Amsterdam, De Nederlandsche Bank, and Duisenberg School of Finance