Bank Regulation under Fire Sale Externalities

Review of Financial Studies, Forthcoming

80 Pages Posted: 19 Jan 2017 Last revised: 18 Jul 2019

See all articles by Gazi Kara

Gazi Kara

Board of Governors of the Federal Reserve System

S. Mehmet Ozsoy

Ozyegin University

Multiple version iconThere are 2 versions of this paper

Date Written: May 2019

Abstract

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

Kara, Gazi and Ozsoy, S. Mehmet, Bank Regulation under Fire Sale Externalities (May 2019). Review of Financial Studies, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2901621

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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