Optimal Liquidity Policy

This paper presents a simple model of liquidity demand and supply. We show that competitive market forces fail to lead to efficient supply of liquidity. The market provision of liquidity is generally too low when the probability of a liquidity event is small and is too high when the probability of a liquidity event is large. Moreover, we show that different policy interventions have different efficiency consequences under different market conditions. For example, while subsidizing liquidity providers ex ante (e.g., designated market makers) is generally efficient, the market liquidity might be too high especially when the probability of liquidity event is small;  spot interventions that subsidize sellers (e.g., relaxing capital requirements, subsidizing loan modifications) is generally more effective at reducing the cost of default than subsidizing buyers (e.g., public-private partnership to purchase toxic assets), especially since subsidization to buyers in the spot market might hinder the incentives of market participants to provide liquidity ex ante.

• The Erasmus Finance Seminar is jointly sponsored by ERIM and the Tinbergen Institute.

This event is an Erasmus Finance Seminar. The Erasmus Finance Seminar series brings prominent researchers in Finance from all over the world to Rotterdam.