An important role of capital and liquidity regulations for financial institutions is to counteract inefficiencies associated with “fire-sale externalities,” such as the tendency of institutions to lever up and hold illiquid assets to the extent that their collective actions increase financial vulnerabilities. However, theoretical models that study such externalities commonly assume perfect competition among financial institutions, in spite of high (and increasing) financial sector concentration. In this post, which is based on our forthcoming article, we consider instead how the effects of fire-sale externalities change when financial institutions have market power.
Prior to the Great Recession, the focus of bank regulation was on bank capital with little consensus about the need for liquidity regulation.
One of the most innovative and potentially far-reaching consequences of regulatory reform since the financial crisis has been the development of liquidity regulations for the banking system.
During the 2007-09 financial crisis, banks experienced widespread funding shortages, with shortfalls even hindering adequately capitalized banks.