When such moral hazard problems are severe, the central bank might consider mitigating but not eliminating the externalities of a liquidity crisis – that is, not helping barely solvent banks and thus providing incentives for banks to conduct business in safe and sound manner.21 The challenge for the central bank is to find the appropriate balance between preserving financial stability and imposing discipline for the future. While the new set of liquidity standards requires banks to hold sufficient liquid assets in good times to meet their outflows in a given stress scenario, it does not exclude the possibility that central bank liquidity support will be needed if events turn out even worse than that scenario. One solution could be to further increase the liquidity requirements. However, additional liquidity requirements aimed at mitigating systemic shocks could constitute a “waste” of liquidity, given that they would be used only under exceptional circumstances. On this note, the emergence of a “home bias” following the global financial crisis poses the risk of an additional “waste” of liquidity. The ring-fencing of capital and liquidity by local supervisors have constrained banks’ risk-taking outside domestic jurisdictions and banks’ ability to transfer and allocate liquidity across jurisdictions in which they operate. Lack of cooperation in the implementation of the new regulatory standards has a potential to lead to overprovision of self-insurance against solvency and liquidity risks, when capital could be invested for a more productive use.

Such coordination failure may arise not because the depositors or the interbank market participants think the bank is likely to be insolvent, but because they anticipate others will withdraw.2 The rationale of liquidity requirements is that they reduce the impact of uncertainty on the bank risk profile, since they allow the bank to withstand larger withdrawals. LOLR and deposit insurance are other ways to achieve the same means: mitigating the risk of a run. The difference is that liquidity requirements are internalised, while LOLR and deposit insurance are externalised to the central bank and to the taxpayers, respectively. Another difference is that liquidity requirements and deposit insurance exert their effects ex ante while LOLR happens after the fact. An additional micro-prudential benefit derived from liquidity requirements relates to a special role of liquid assets. By maintaining liquidity buffers in advance, banks commit to removing solvency risk from a portion of their portfolio. This limits solvency risk and encourages good risk management, acting as a prudential regulatory tool alongside other requirements, such as capital buffers or bail-inable debt, that also exert discipline on bank risk-taking behaviour.3 A counterargument is however that holding a large balance of liquid assets gives bank management too much discretion and can thus create agency problems.4 Liquidity standards should also be designed to mitigate adverse effects owing to inherently systemic characteristics of a liquidity crisis. The reaction of one bank to liquidity strains might create major liquidity strains for other banks.