The Chinese University of Hong Kong-Tsinghua University Joint Research Center for Chinese Economy 清華大學-香港中文大學中國經濟聯合研究中心 - Liquidity Regulation and Unintended Financial Transformation in China The Chinese University of Hong Kong-Tsinghua University <br/>Joint Research Center for Chinese Economy 清華大學-香港中文大學中國經濟聯合研究中心
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Liquidity Regulation and Unintended Financial Transformation in China
Kinda Cheryl Hachem, Zheng Michael Song

Many countries try to mitigate business cycle fluctuations by regulating the activities of their banks. We develop a theoretical framework to study the endogenous response of the banking sector and the implications for the aggregate economy. Under fairly mild conditions, we find that stricter liquidity standards can generate unintended credit booms as attempts to arbitrage the regulation change the allocation of savings across banks and the allocation of lending across markets. We then apply our framework to study recent events in China. We show that a regulatory push to increase bank liquidity and cap loan-to-deposit ratios in the late 2000s accounts for one-third of China ’s unprecedented credit boom and one-half of the increase in interbank interest rates over the same period. We also find strong empirical support for the cross-sectional differences between big and small banks predicted by the model.

567
0017
Liquidity Regulation and Unintended Financial Transformation in China
Kinda Cheryl Hachem, Zheng Michael Song

Many countries try to mitigate business cycle fluctuations by regulating the activities of their banks. We develop a theoretical framework to study the endogenous response of the banking sector and the implications for the aggregate economy. Under fairly mild conditions, we find that stricter liquidity standards can generate unintended credit booms as attempts to arbitrage the regulation change the allocation of savings across banks and the allocation of lending across markets. We then apply our framework to study recent events in China. We show that a regulatory push to increase bank liquidity and cap loan-to-deposit ratios in the late 2000s accounts for one-third of China ’s unprecedented credit boom and one-half of the increase in interbank interest rates over the same period. We also find strong empirical support for the cross-sectional differences between big and small banks predicted by the model.

567