Liquidity and central bank policy

These things a twenty first century central banker knows:

The corporate world is gotten more complex since the advent of financial engineering.  The continuous expectation of investors to maximise risk adjusted returns leads to increased chances that the firm might succumb  to the temptation of gearing, with the result that the firm goes out of business.  Not all firms are exposed evenly to this risk - it clusters, and those industries most at risk are those with funding and asset mismatches.  This is almost the definition of the base business model of retail banking sector.  So banks have to set up shop at the foot of the volcano.  That's their job.  And those banks all have to do this, to a greater or lesser extent.

If a central banker want to avoid systemic risks, he tries to put in place measures which address this risk.  Perhaps a demand for higher capital buffers (some of which capital operates a s a liquidity buffer).  But banks respond to these capital requirements by grossing down their balance sheets rather than taking the direct hit to their share price as a result of the likely reduction in equity returns which happens when the regulator asks banks to sit on more capital.  

In the limit, the banks become not only heavily regulated by government, but the key mechanism for allocating credit (capital) to those parts of the economy that need it becomes a quasi-government function.  Bank returns become largely policy driven and the financial services industry starts to resemble a government department with ludicrously paid employees.  It is not that regulator imposition has unforeseen effects on liquidity of firms and systemic liquidity per so, it is that these banks need to place their business at the foot of the volcano in the first place.  You can't legislate geography away, so to speak.

When firms go bust, they often go through an illiquidity phase on their way to extinction.  This must continue to happen for Schumpeterian reasons, so policy setters need to distinguish when to act and when not to act.  This determines their actions vis-a-vis their role as final liquidity providers - i.e. lenders of last resort.  But if you do this too generously you end up with an economy of zombie corporations - Japan has faced this situation for decades.  And if you don't do it too actively, you enable avoidable contractions and recessions.  The ease with which various central banks pull this trigger largely drives the modern discussion of progressivism versus the Austrian or neo-classical approach in politics. 

Finally, even if central bankers and policy makers decided that they'd run the risk of forcing banks to hold dramatically more capital, as a kind of ground zero solution to the negative consequences of the inherently systemic nature of banking, the industry would migrate increasingly to the shadow banking sector.  This is already happening to some degree - witness the birth of so-called peer to peer lending.