Enough Liquidity with Enough Capital—and Vice Versa?

Hans Gersbach, Hans Haller and Sebastian Zelzner

No 19072, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: We study the interplay of capital and liquidity regulation in a general equilibrium setting by focusing on future funding risks. The model consists of a banking sector with long-term illiquid investment opportunities that need to be financed by short-term debt and by issuing equity. Reliance on refinancing long-term investment in the middle of the life-time is risky, since the next generation of potential short-term debt holders may not be willing to provide funding when the return prospects on the long-term investment turn out to be bad. For moderate return risk, equilibria with and without bank default coexist, and bank default is a self-fulfilling prophecy. Capital and liquidity regulation can prevent bank default and may implement the first-best. Yet the former is more powerful in ruling out undesirable equilibria and thus dominates liquidity regulation. Adding liquidity regulation to optimal capital regulation is redundant.

Keywords: Financial intermediation; Funding risk; Bank default; Banking regulation; Liquidity requirements; Capital requirements (search for similar items in EconPapers)
JEL-codes: G21 G33 G38 (search for similar items in EconPapers)
Date: 2024-05
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