European Central Bank publishes working paper finding liquidity requirements alone cannot deliver an efficient banking sector structure

The European Central Bank has published a working paper that develops a theoretical framework for bank liquidity regulation and concludes that higher liquidity requirements can improve banks’ risk-management incentives but are not sufficient on their own to achieve an efficient financial system structure. In the paper, which is explicitly presented as reflecting the authors’ views rather than those of the ECB, liquidity demand arises from agency problems in leveraged banking rather than from exogenous funding shocks. The core result is that liquidity rules can reduce reliance on fire sales and strengthen prudent behavior inside banks, but by themselves still leave the banking sector too large relative to non-bank liquidity providers. The model links banks’ ex ante cash holdings to market liquidity and the allocation of intermediation between banks and non-bank investors that can buy assets in stress periods. It finds that, in an unregulated equilibrium, banks hold too little liquidity and rely too heavily on asset sales in bad states, while too many financial experts choose leveraged banking over equity-financed non-bank liquidity provision. A planner’s allocation therefore requires two policy tools: liquidity requirements to address incentive problems within banks, plus a second instrument such as limits on bank size or measures that encourage equity-financed liquidity provision outside the banking sector. The paper also contrasts this logic with the Basel III Liquidity Coverage Ratio, arguing that liquidity buffers can matter even when they are not drawn down because their presence changes ex ante incentives.