Unintended Consequences of Post-Crisis Liquidity Regulation

Abstract

We present evidence that post-crisis liquidity regulation on commercial banks and money market funds (MMFs) unintentionally shifts liquidity transformation into the Federal Home Loan Bank (FHLB) System, a government-sponsored enterprise. We find that commercial banks increased significantly their borrowing from FHLB advances to meet the liquidity requirements imposed by Basel III, while MMFs increased their lending to FHLBs in response to the Money Market Reform. Since the FHLBs are backed by an implicit government guarantee, the new realignment between banks, FHLBs, and MMFs increases the reliance of private financial institutions on public liquidity on a regular basis, which is inconsistent with the intention of the post-crisis liquidity regulation. Furthermore, the subsidy associated with the implicit government guarantee is largely captured by banks and FHLBs rather than being passed to intended recipients. We argue that the main cause of this unintended consequence is regulatory fragmentation.