On Regulation and Excess Reserves: The Case of Basel III

Abstract

Recent studies suggest liquidity regulation contributed to the rise in excess reserves, but capital regulations may matter, too. We use a simple model to show that banks may tilt portfolios away from higher risk-weighted assets like loans and toward lower risk-weighted assets like reserves and Treasuries in response to higher risk-based capital requirements, but not in response to higher non-risk-based capital requirements. Empirical results suggest that advanced approaches banks, which were the focus of Basel III capital regulations that preceded Basel III liquidity regulations, held more excess reserves than smaller large banks after the regulatory changes, before later substituting Treasuries for these reserves.

Keywords: bank capital regulation, bank liquidity regulation, interest on reserves, unintended consequences

JEL Classification: E02, F33, G01, G18, G28