Liquidity, capital requirements, and shadow banking

Zehao Liu and Chengbo Xie

International Review of Economics & Finance, 2021, vol. 76, issue C, 1379-1388

Abstract: We study the role of capital requirements in adjusting market liquidity. Liquidity is necessary as it prevents fire sales and suppresses the risk-shifting problem when a negative shock occurs. However, hoarding excessive liquidity is costly as it crowds out efficient investments. A capital requirement on commercial banks reduces deposit returns. This causes investors to allocate more resources to more efficient capital market investments, improving social welfare. However, an excessively high capital requirement is undesirable because the return from holding liquidity is so low that liquidity provision is insufficient to avoid risk-shifting behaviors. Shadow banks can bypass capital regulation, and strict capital regulation will drive money to shadow banks. Thus, a liquidity shortage emerges because shadow bank securities are less liquid than commercial bank deposits. Policy maker should implement lower capital requirements in the presence of shadow banks.

Keywords: Liquidity; Capital requirements; Shadow banking; Inefficient liquidity hoarding; Regulatory arbitrage (search for similar items in EconPapers)
JEL-codes: E58 G21 G28 (search for similar items in EconPapers)
Date: 2021
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:reveco:v:76:y:2021:i:c:p:1379-1388

DOI: 10.1016/j.iref.2019.11.019

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