Unintended Consequences of Post-Crisis Liquidity Regulation
Suresh M. Sundaresan, Columbia Business School – Finance and Economics
Kairong Xiao, Columbia University – Columbia Business School
This paper evaluates the effects of the newly introduced liquidity regulation on the U.S. banking system. We find that although liquidity regulation has reduced banks’ issuance of short-term money-like claims, it has unintentionally increased banks’ borrowing from government-sponsored enterprises known as the Federal Home Loan Banks (FHLBs). We show that such borrowing is motivated by regulatory arbitrage: because the FHLBs are not subject to liquidity regulation, they can issue short-term money-like claims at lower costs and lend to banks. We argue that this regulatory arbitrage compromises the effectiveness of liquidity regulation and creates potential fragilities in the financial system.