Inefficiency and Regulation of Private Liquidity

We propose a simple model to study the efficiency of private liquidity creation by financial intermediaries. Liquidity is provided by both safe and risky debt, and liquidity crises arise when risky debt is defaulted on and stops providing liquidity services. Because of a novel externality related to liquidity premia and the cost of issuing safe debt, the equilibrium is inefficient and characterized by an excessive supply of risky debt. However, the optimal regulation requires that not only risky but also safe debt be targeted, and regulating risky debt alone has unintended welfare-reducing consequences