Central Bank Liquidity Backstops, Bank Regulation, and Risk-Taking by Asset Managers
Abstract
Central bank liquidity backstops and bank leverage regulation interact across financial intermediaries and states of the world. A backstop is implemented only in some states to grease the wheels of bank dealers that absorb fire sales. It also incentivizes asset managers to take on excessive redemption risk. Regulation binds in other states, in which it hamstrings market making. Because this outcome increases asset managers’ fire sale costs, it reins in their risk-taking. Empirically, we confirm such a disciplining effect of regulation on U.S. money market funds. Theoretically, we derive that the two policy measures complement each other in raising social welfare because they address different sources of redemption-driven losses—fire sale costs for given risk-taking and excessive risk-taking, respectively.