This paper analyses the impact of different treatments of government bonds in bank liquidity regulation on financial stability. Using a theoretical model, we show that a sudden increase in sovereign default risk (government bond shock) may lead to liquidity issues in the banking sector implying the insolvency of a significant number of banks. Liquidity requirements do not increase the government-bond-shock-absorbing capacity of the banking sector.
In this sense they do not increase financial stability. The shock-absorbing capacity will increase if a central bank as a lender of last resort exists. However, then the introduction of liquidity requirements in general and the repealing of the preferential treatment of government bonds in liquidity regulation in particular actually reduce the government-bond-shock-absorbing capacity. The driving force is a regulation-induced change in bank investment behaviour.