Bank Regulation under Fire Sale Externalities
Review of Financial Studies, Forthcoming
80 Pages Posted: 19 Jan 2017 Last revised: 18 Jul 2019
Date Written: May 2019
We examine the optimal design of and interaction between capital and liquidity regulations. Banks, not internalizing fire sale externalities, overinvest in risky assets and underinvest in liquid assets in the competitive equilibrium. Capital requirements can alleviate the inefficiency, but banks respond by decreasing their liquidity ratios. When capital requirements are the only available tool, the regulator tightens them to offset banks' lower liquidity ratios, leading to fewer risky assets and less liquidity compared with the second best. Macroprudential liquidity requirements that complement capital regulations implement the second best, improve financial stability, and allow for more investment in risky assets.
Keywords: Bank Capital Regulation, Liquidity Regulation, Fire Sale Externalities, Basel III
JEL Classification: G20, G21, G28
Suggested Citation: Suggested Citation