Insolvency-Illiquidity, Macro Externalities and Regulation

Ester Faia

No 14055, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: This paper studies the optimal design of equity and liquidity regulations in a dynamic macro model with information-based bank runs. Although the latter are privately efficient, since they discipline bank managers efforts into the projects' re-deploying activity, they induce aggregate externalities. Technological inefficiencies arise if bank managers extract rents which are higher than the technological costs of re-deploying projects. Pecuniary externalities arise since, when choosing leverage, bank managers do not internalize the fall in asset price ensuing from the aggregate costs of projects' liquidation in a run event. This creates scope for regulation. Equity and liquidity requirements are complementary, as the first tackles the solvency region, while the second the illiquid-solvent one. Finally, in presence of anticipatory effects prudential policies may have unintended consequences as banks adjust their behaviour when a shift in prudential regime is announced. The more so the higher the credibility of the announcement.

Keywords: Information-based bank runs; Pecuniary externalities; Ramsey plan; Basel regimes; Equity requirements; Liquidity requirements (search for similar items in EconPapers)
JEL-codes: E0 E5 G01 (search for similar items in EconPapers)
Date: 2019-10
New Economics Papers: this item is included in nep-ban, nep-cba and nep-mac
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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