Enough liquidity with enough capital - And vice versa?

Hans Gersbach, Hans Haller and Sebastian Zelzner

No 714, CFS Working Paper Series from Center for Financial Studies (CFS)

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: 2023
New Economics Papers: this item is included in nep-ban, nep-cba, nep-cfn, nep-fdg and nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:zbw:cfswop:714

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