Insolvency-Illiquidity, Macro Externalities and Regulation

61 Pages Posted: 17 Oct 2019 Last revised: 23 Oct 2019

See all articles by Ester Faia

Ester Faia

Goethe University Frankfurt; Kiel Institute for the World Economy; University of Angers - Centre d'Etudes Prospectives d'Economie Mathematique Appliquees a la Planification (CEPREMAP)

Date Written: October 2019

Abstract

This paper studies the optimal design of equity and liquidity regulations in a dynamic macro model with information-based bank runs. Although the latter are privately efficient, since they discipline bank managers efforts into the projects' re-deploying activity, they induce aggregate externalities. Technological inefficiencies arise if bank managers extract rents which are higher than the technological costs of re-deploying projects. Pecuniary externalities arise since, when choosing leverage, bank managers do not internalize the fall in asset price ensuing from the aggregate costs of projects' liquidation in a run event. This creates scope for regulation. Equity and liquidity requirements are complementary, as the first tackles the solvency region, while the second the illiquid-solvent one. Finally, in presence of anticipatory effects prudential policies may have unintended consequences as banks adjust their behaviour when a shift in prudential regime is announced. The more so the higher the credibility of the announcement.

Keywords: Basel regimes, equity requirements, information-based bank runs, liquidity requirements, Pecuniary externalities, Ramsey plan

JEL Classification: E0, E5, G01

Suggested Citation

Faia, Ester, Insolvency-Illiquidity, Macro Externalities and Regulation (October 2019). CEPR Discussion Paper No. DP14055. Available at SSRN: https://ssrn.com/abstract=3471249

Ester Faia (Contact Author)

Goethe University Frankfurt ( email )

Grüneburgplatz 1
Frankfurt am Main, 60323
Germany

Kiel Institute for the World Economy

P.O. Box 4309
Kiel, Schleswig-Hosltein D-24100
Germany

University of Angers - Centre d'Etudes Prospectives d'Economie Mathematique Appliquees a la Planification (CEPREMAP)

Ecole Normale Superieure
48 boulevard Jourdan
75014 Paris
France

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