Liquidity Regulation and the Transmission of Lending Shocks Across Borders

Abstract

We investigate how liquidity regulation affects the transmission of negative wholesale funding shocks from the largest OECD global banks to the lending of their foreign subsidiaries across 98 countries. Controlling for adverse solvency shocks, which we argue is very important for identification, we find that, surprisingly, liquidity regulation exacerbates the transmission of adverse wholesale shocks. These findings suggest that liquidity regulation has a destabilizing effect for the host market. The effect is driven primarily by countries with floating exchange rate regimes and less so by countries with currency boards and other exchange rate management arrangements, such as dollarization. The results from our global study provide important lessons for Bulgaria in its transition from a currency board to a euro area membership.