The effect of regulatory requirements on market liquidity: ESG promotion as a special case

Liquidity is a key consideration in financial markets, especially in times of financial crises. For this reason, regulatory attention to and measures in this field have been on the rise for the past several years. As a matter of fact, regulations aiming at ensuring funding liquidity or, in general, reducing certain risky positions have the side effect of reducing market liquidity. To understand this effect, we extend a standard general equilibrium model with transaction costs of trading, endogenous market liquidity, and the modeling of regulation. We prove that both funding liquidity regulation in general and divesting bad ESG assets, in particular, reduce market liquidity.