Traditionally, aggregate liquidity shocks are modelled as exogenous events. Extending our previous work (Cao & Illing …, 2008), this paper analyses the adequate policy response to endogenous systemic liquidity risk. We analyse the feedback … between lender of last resort policy and incentives of private banks, determining the aggregate amount of liquidity available …

intermediaries' incentives for liquidity transformation are affected by the central bank's reaction to financial crisis. Anticipating … central bank's reaction to liquidity stress gives banks incentives to invest in excessive liquidity transformation, triggering … efficient outcome can be implemented by imposing ex ante liquidity requirements. …