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Liquidity Requirements and the Interbank Loan Market: An Experimental Investigation


We develop a stylized interbank market environment and use it to evaluate with experimental methods the effects of liquidity requirements. Baseline and liquidity-regulated regimes are analyzed in a simple shock environment, which features a single idiosyncratic shock, and in a compound shock environment, in which the idiosyncratic shock is followed by a randomly occurring second-stage shock. Interbank trading of the illiquid asset follows each shock. In the simple shock environment, we find that liquidity regulations reduce the incidence of bankruptcies, but at a large loss of investment efficiency. In the compound shock environment, liquidity regulations not only impose a loss of investment efficiency but also fail to reduce bankruptcies.

Keywords: Interbank market, liquidity regulation, market experiments

JEL codes: C9, G21

Associated files available: Experiment instructions, data, and a series of unpublished appendices are available at http://www.people.vcu.edu/~dddavis.


Suggested citation: Davis, Douglas, Oleg Korenok, John Lightle, and Edward Simpson Prescott. 2018. “Liquidity Requirements and the Interbank Loan Market: An Experimental Investigation.” Federal Reserve Bank of Cleveland, Working Paper no. 18-10. https://doi.org/10.26509/frbc-wp-201810.

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