Modelling the liquidity ratio as macroprudential instrument

The Basel III Liquidity Coverage Ratio (LCR) is a microprudential instrument to strengthen the liquidity position of banks. However, if in extreme scenarios the LCR becomes a binding constraint, the interaction of bank behaviour with the regulatory rule can have negative externalities. We simulate the systemic implications of the LCR by a liquidity stress-testing model, which takes into account the impact of bank reactions on second round feedback effects. We show that a flexible approach of the LCR, in particular one that recognises less liquid assets in the buffer, is a useful macroprudential instrument to mitigate its adverse side effects during times of stress. At extreme stress levels the instrument becomes ineffective and the lender of the last resort has to underpin the stability of the system.