Finance and Economics Discussion Series (FEDS)
February 2022
Balancing Before and After: Treasury Market Reform Proposals and the Connections Between Ex-Ante and Ex-Post Liquidity Tools
Abstract:
This paper develops a simple framework that helps to draw out some of the potential connections between ex-ante liquidity risk management tools such as liquidity requirements or mandatory fees and ex-post liquidity tools such as a lender of last resort. A central message of this analysis is that policy actions that expand the lender of last resort function so as to better address periods of financial distress are likely to be most effective when accompanied by regulations or other mechanisms that encourage socially-responsible ex-ante liquidity risk management on the part of financial firms. Regulation in the form of a liquidity coverage requirement can be helpful in moving private sector outcomes toward a social optimum. A mandatory fee schedule also emerges as a potentially very useful tool. The structure of the optimal fee schedule depends on both the scale of volatile liabilities and the extent of “liquidity coverage” maintained to cover potential funding shortfalls. Both liquidity requirements and mandatory fees can help to address a form of time consistency problem in connection with the provision of ex-post liquidity support through a lender of last resort. The framework also provides some potentially useful benchmarks in evaluating the distribution of liquidity risks across different classes of financial firms.
Keywords: Lender of Last Resort, Liquidity Regulation, Treasury Market
DOI: https://doi.org/10.17016/FEDS.2022.004
PDF: Full Paper
Related Materials: Accessible materials (.zip)
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