Liquidity Safety Nets for Banks

Abstract

Liquidity shocks are a core risk of the business model of commercial banks, which is founded on a liquidity mismatch between the banks' liabilities and assets. A substantial part of the banks' funding comes from short-term retail and wholesale funding, whilst a substantial part of the assets are long-term and illiquid loans. This is the source of the banks' profi ts, but also of their claim to fulfi l an important social role. Having argued that leaving the solution to this problem to the banks alone is unsafe, this article turns to examine three regulatory strategies for reducing the incidence of liquidity shocks or making banks more resilient to them. They are: regulating the level of banks' liquidity reserves, insuring the value of the banks' long-term assets and guaranteeing the discharge of the banks' short-term liabilities. The criteria of assessment are the least impact on the banks' social role of transforming short-term deposits into long-term loans, coupled with the least incentive for banks to take excessive risk, the least subsidy to banking and the least cost to the public purse. It is suggested that insuring the value of the banks' long-term assets emerges as the most attractive strategy.