Who Should Provide 'Liquidity Services'? Systemic Risks, Consumer Protection and Financial Regulation.

Abstract

By liquidity services, we mean in this paper the whole set of key activities which permit that the final holders of financial claims may switch to cash when needed while nevertheless providing stable long term financing to companies and households. Secondary securities markets, financial institutions, collective investment vehicles and public entities, all participate in a complex way to this alchemy, sometimes in competition with each other. We stress that there is no level-playing field: this competition is heavily biased by two public distortions, i.e. the well-known unfortunate tax-bias which penalizes equity-based institutions and the refinancing backstops supplied at non-market conditions to banks by monetary authorities. These distortions contribute to the systemic vulnerability of the financial system by encouraging a complex circuit where credit risks may be driven outside an under-capitalized banking sector, while banks stay exposed to many liquidity risks. Contrary to a significant part of the literature, we see little convincing “market failures” to justify these large distortions which both penalize and subsidy different types of banking activities. In this context, reducing the maturity transformation role played by banks, either through direct regulations or hopefully following the correction of the current distortions, could make financial systems more stable. Yet, as their role should increase, we stress the importance to better regulate how collective investment funds provide, in competition with the banks, some of the liquidity required by investors. Due to “bounded rationality” and the public good nature of information, it is unlikely that investors alone can impose best practices as far as valuation and redemption policies are concerned.