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Bank regulation under fire sale externalities

Gazi Kara () and S. Mehmet Ozsoy

No 2016-026, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (US)

Abstract: This paper examines the optimal design of and interaction between capital and liquidity regulations in a model characterized by fire sale externalities. In the model, banks can insure against potential liquidity shocks by hoarding sufficient precautionary liquid assets. However, it is never optimal to fully insure, so realized liquidity shocks trigger an asset fire sale. Banks, not internalizing the fire sale externality, overinvest in the risky asset and underinvest in the liquid asset in the unregulated competitive equilibrium. Capital requirements can lead to less severe fire sales by addressing the inefficiency and reducing risky assets -- however, we show that banks respond to stricter capital requirements by decreasing their liquidity ratios. Anticipating this response, the regulator preemptively sets capital ratios at high levels. Ultimately, this interplay between banks and the regulator leads to inefficiently low levels of risky assets and liquidity. Macroprudential liquidity requirements that complement capital regulations, as in Basel III, restore constrained efficiency, improve financial stability and allow for a higher level of investment in risky assets.

Keywords: Bank capital regulation; liquidity regulation; fire sale externality; Basel III (search for similar items in EconPapers)
JEL-codes: G20 G21 G28 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ban, nep-cba and nep-rmg
Date: 2016-03
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (8) Track citations by RSS feed

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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedgfe:2016-26

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DOI: 10.17016/FEDS.2016.026

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