Jointly Optimal Regulation of Bank Capital and Liquidity

Abstract

In an economy with financial frictions, banks endogenously choose excessive leverage and maturity mismatch in equilibrium, as they fail to internalize the risk of socially wasteful fire sales. Macroprudential regulators can achieve efficiency with simple linear constraints, which require less information than Pigouvian taxes. The liquidity coverage and net stable funding ratios of Basel III can implement efficiency. Additional microprudential regulation of leverage is required when bank failures are socially costly. Micro‐ and macroprudential rules are imperfect substitutes. Optimally, macroprudential policy reacts to systematic risk and credit conditions over the cycle, while microprudential policy reacts to systematic and idiosyncratic risk.

The Impact of Prudential Regulation on Jordanian Banks Liquidity

“…Diamond and Dybvig's model, a demand for liquidity in banks increases because customers face privately observed risks and liquidation is costly [20].…”

Macroeconomic Modeling of Financial Frictions for Macroprudential Policymaking: A Review of Pressing Challenges

“…For example, in their paper, optimal regulation does not necessarily involve capital or liquidity regulations. Walther (2015) also studies macroprudential regulation in a model characterized by pecuniary externalities due to fire sales. In his setup, the fire sale price is exogenously fixed and the socially optimal outcome is to have "no fire sales" in equilibrium, whereas in our paper partial fire sales are not only allowed, they are also optimal.…”

The Effects of Liquidity Regulation on Bank Demand in Monetary Policy Operations

“…Diamond and Kashyap (2015) investigate the effects of liquidity regulation on bank runs. Walther (2016) examines the effects of a liquidity regulation similar to the net stable funding ratio and capital requirements on systemic risk. We contribute to these papers with empirical evidence that liquidity regulation affects bank behavior materially, which is an important feature of their models.…”