Liquidity provision and optimal bank regulation

Oz Shy and Rune Stenbacka

International Journal of Economic Theory, 2007, vol. 3, issue 3, 219-233

Abstract: We extend the set of regulatory instruments for banks' liquidity provision by adding a policy instrument for controlling the fraction of perfectly‐liquid accounts. We demonstrate how this instrument induces self‐selection on behalf of depositors who are differentiated according to their probability of facing a liquidity shock. This self‐selection leads to a market segmentation, which can break the bundling of deposits with liquidity risk and, thereby, enhance welfare. The optimal regulatory policy is explicitly characterized as a function of banks' investment return, and of depositors' gain from early withdrawals to fund a realized investment opportunity.

Date: 2007
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https://doi.org/10.1111/j.1742-7363.2007.00057.x

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Persistent link: https://EconPapers.repec.org/RePEc:bla:ijethy:v:3:y:2007:i:3:p:219-233

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