Macroprudential Policy with Liquidity Panics.

The article analyzes the optimality of macroprudential policies in a theoretical model where banks provide liquidity to firms but face informational frictions that can cause interbank market freezes. These freezes prompt firms to hoard liquidity, reducing their demand for bank loans and bank profitability, which in turn increases the likelihood of further freezes, creating a feedback loop termed a "liquidity panic." The model shows that liquidity requirements on banks, such as those mandating reserves, can alleviate these frictions, reduce liquidity hoarding by firms, and paradoxically increase aggregate investment and welfare. Conversely, policies encouraging bank lending, like subsidies to bank financing, may worsen crises by lowering bank profitability and increasing the probability of market freezes. Empirical evidence from the Global Financial Crisis and COVID-19 pandemic supports the model's prediction of simultaneous runs on both banks' liabilities and assets, highlighting the importance of considering corporate sector responses in macroprudential policy design.