We develop a stylized interbank market environment and use it to evaluate with experimental methods the effects of liquidity requirements. Baseline and liquidity-regulated regimes are analyzed in a simple shock environment, which features a single idiosyncratic shock, and in a compound shock environment, in which the idiosyncratic shock is followed by a randomly occurring second-stage shock. Interbank trading of the illiquid asset follows each shock. In the simple shock environment, we find that liquidity regulations reduce the incidence of bankruptcies, but at a large loss of investment efficiency. In the compound shock environment, liquidity regulations not only impose a loss of investment efficiency but also fail to reduce bankruptcies.
The full report is available at https://www.clevelandfed.org/en/newsroom-and-events/publications/working-papers/2018-working-papers/wp-1810-liquidity-requirements-and-the-interbank-loan-market.aspx