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Bank Regulation Under Fire Sale Externalities

80 Pages Posted: 5 Apr 2016  

Gazi Kara

Board of Governors of the Federal Reserve System

S. Mehmet Ozsoy

Ozyegin University

Date Written: 2016-03

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

JEL Classification: G20, G21, G28

Suggested Citation

Kara, Gazi and Ozsoy, S. Mehmet, Bank Regulation Under Fire Sale Externalities (2016-03). FEDS Working Paper No. 2016-026. Available at SSRN: https://ssrn.com/abstract=2759216 or http://dx.doi.org/10.17016/FEDS.2016.026

Gazi Kara (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

S. Mehmet Ozsoy

Ozyegin University ( email )

Kusbakisi Cd. No: 2
Altunizade, Uskudar
Istanbul, 34662
Turkey

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