IDEAS home Printed from https://ideas.repec.org/p/ecb/ecbwps/20263252.html

A theory of bank liquidity requirements

Author

Listed:
  • Castells-Jauregui, Madalen
  • Heider, Florian
  • Hoerova, Marie
  • Calomiris, Charles

Abstract

We develop a general equilibrium theory of financial intermediation and its implications for liquidity regulation. The model is built around an agency problem arising from leveraged intermediation: banks finance loan origination with deposits and face moral hazard in risk management, while holding cash mitigates these incentives at the cost of foregone investment returns. Liquidity demand therefore emerges endogenously from incentive considerations rather than from exposure to exogenous funding shocks. In equilibrium, financial experts choose between allocating equity to the banking sector relative to the non-bank financial sector that can provide ex-post liquidity by buying bank assets. Asset prices are determined endogenously in liquidation states, linking banks’ ex ante liquidity choices to market liquidity and the allocation of intermediation across sectors. Comparing the decentralized equilibrium to a planner’s allocation, we show that liquidity regulation mandating higher cash holdings improves incentives within banks but is not sufficient to implement the efficient allocation. In particular, it leads to an inefficiently large banking sector that free-rides on liquidity provision by non-bank investors. Implementing the planner’s allocation requires a second policy instrument, such as limits on bank size or subsidies to equity-financed liquidity provision outside the banking sector. JEL Classification: G21, G28, D82, D6

Suggested Citation

  • Castells-Jauregui, Madalen & Heider, Florian & Hoerova, Marie & Calomiris, Charles, 2026. "A theory of bank liquidity requirements," Working Paper Series 3252, European Central Bank.
    • Handle: RePEc:ecb:ecbwps:20263252
    Note: 276127
    as

    Download full text from publisher

    File URL: https://www.ecb.europa.eu//pub/pdf/scpwps/ecb.wp3252~91761af52b.en.pdf
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. Balke, Nathan S & Gordon, Robert J, 1989. "The Estimation of Prewar Gross National Product: Methodology and New Evidence," Journal of Political Economy, University of Chicago Press, vol. 97(1), pages 38-92, February.
    2. Jeremy C. Stein, 2012. "Monetary Policy as Financial Stability Regulation," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 127(1), pages 57-95.
    3. Frederic Malherbe, 2014. "Self-Fulfilling Liquidity Dry-Ups," Journal of Finance, American Finance Association, vol. 69(2), pages 947-970, April.
    4. Calomiris,Charles W., 2000. "U.S. Bank Deregulation in Historical Perspective," Cambridge Books, Cambridge University Press, number 9780521583626.
    5. Willard Long Thorp, 1926. "The Annals of the United States of America," NBER Chapters, in: Business Annals, pages 107-145, National Bureau of Economic Research, Inc.
    6. Gazi I Kara & S Mehmet Ozsoy & Itay Goldstein, 2020. "Bank Regulation under Fire Sale Externalities," The Review of Financial Studies, Society for Financial Studies, vol. 33(6), pages 2554-2584.
    7. Emmanuel Farhi & Mikhail Golosov & Aleh Tsyvinski, 2009. "A Theory of Liquidity and Regulation of Financial Intermediation," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 76(3), pages 973-992.
    8. Bengt Holmstrom & Jean Tirole, 1997. "Financial Intermediation, Loanable Funds, and The Real Sector," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 112(3), pages 663-691.
    9. Ansgar Walther, 2016. "Jointly Optimal Regulation of Bank Capital and Liquidity," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 48(2-3), pages 415-448, March.
    10. Goodhart, C., 2008. "Liquidity risk management," Financial Stability Review, Banque de France, issue 11, pages 39-44, February.
    11. Bengt Holmstrom & Jean Tirole, 1998. "Private and Public Supply of Liquidity," Journal of Political Economy, University of Chicago Press, vol. 106(1), pages 1-40, February.
    12. Romer, Christina D., 1994. "Remeasuring Business Cycles," The Journal of Economic History, Cambridge University Press, vol. 54(3), pages 573-609, September.
    13. Davis, Joseph H., 2006. "An Improved Annual Chronology of U.S. Business Cycles since the 1790s," The Journal of Economic History, Cambridge University Press, vol. 66(1), pages 103-121, March.
    14. Guido Lorenzoni, 2008. "Inefficient Credit Booms," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 75(3), pages 809-833.
    15. Enrico Perotti & Javier Suarez, 2011. "A Pigovian Approach to Liquidity Regulation," International Journal of Central Banking, International Journal of Central Banking, vol. 7(4), pages 3-41, December.
    16. Charles W. Calomiris & Gary Gorton, 1991. "The Origins of Banking Panics: Models, Facts, and Bank Regulation," NBER Chapters, in: Financial Markets and Financial Crises, pages 109-174, National Bureau of Economic Research, Inc.
    17. Anil K Kashyap & Dimitrios P. Tsomocos & Alexandros P. Vardoulakis, 2024. "Optimal Bank Regulation in the Presence of Credit and Run Risk," Journal of Political Economy, University of Chicago Press, vol. 132(3), pages 772-823.
    18. Sundaresan, Suresh & Xiao, Kairong, 2024. "Liquidity regulation and banks: Theory and evidence," Journal of Financial Economics, Elsevier, vol. 151(C).
    19. Arthur F. Burns & Wesley C. Mitchell, 1946. "Measuring Business Cycles," NBER Books, National Bureau of Economic Research, Inc, number burn46-1, December.
    20. Xavier Vives, 2014. "Strategic Complementarity, Fragility, and Regulation," The Review of Financial Studies, Society for Financial Studies, vol. 27(12), pages 3547-3592.
    21. Douglas W. Diamond, 1984. "Financial Intermediation and Delegated Monitoring," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 51(3), pages 393-414.
    22. Kinda Hachem & Zheng Song, 2021. "Liquidity Rules and Credit Booms," Journal of Political Economy, University of Chicago Press, vol. 129(10), pages 2721-2765.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Gazi I Kara & S Mehmet Ozsoy & Itay Goldstein, 2020. "Bank Regulation under Fire Sale Externalities," The Review of Financial Studies, Society for Financial Studies, vol. 33(6), pages 2554-2584.
    2. Stijn Claessens & M Ayhan Kose, 2018. "Frontiers of macrofinancial linkages," BIS Papers, Bank for International Settlements, number 95.
    3. Sundaresan, Suresh & Xiao, Kairong, 2024. "Liquidity regulation and banks: Theory and evidence," Journal of Financial Economics, Elsevier, vol. 151(C).
    4. Santos, João A.C. & Suarez, Javier, 2019. "Liquidity standards and the value of an informed lender of last resort," Journal of Financial Economics, Elsevier, vol. 132(2), pages 351-368.
    5. Roberto Robatto, 2024. "Liquidity Requirements and Central Bank Interventions During Banking Crises," Management Science, INFORMS, vol. 70(2), pages 1175-1193, February.
    6. Mirza, Afrasiab & Stephens, Eric, 2022. "Securitization and aggregate investment efficiency," Journal of Financial Intermediation, Elsevier, vol. 52(C).
    7. Eric Cuijpers & Razvan Vlahu, 2026. "Cross-border banking, intragroup exposures and risk-taking," Working Papers 854, DNB.
    8. Robin Döttling, 2025. "Bank Capital Regulation in a Zero Interest Environment," Journal of the European Economic Association, European Economic Association, vol. 23(3), pages 1028-1059.
    9. Luck, Stephan & Schempp, Paul, 2023. "Inefficient liquidity creation," Journal of Financial Intermediation, Elsevier, vol. 53(C).
    10. Okahara, Naoto, 2020. "Liquidity requirement and banks' lending," MPRA Paper 101816, University Library of Munich, Germany.
    11. Sebastian Doerr & Mathias Drehmann, 2026. "The liquidity coverage ratio a decade on: a stocktake of the literature," BIS Papers, Bank for International Settlements, number 164.
    12. Golec, Pascal & Perotti, Enrico, 2017. "Safe assets: a review," Working Paper Series 2035, European Central Bank.
    13. Ansgar Walther, 2014. "Jointly optimal regulation of bank capital and maturity structure," Economics Series Working Papers 725, University of Oxford, Department of Economics.
    14. Emmanuel Farhi & Jean Tirole, 2021. "Shadow Banking and the Four Pillars of Traditional Financial Intermediation," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 88(6), pages 2622-2653.
    15. Ryuichiro Izumi & Yang Li, 2021. "Financial Stability with Fire Sale Externalities," Wesleyan Economics Working Papers 2021-002, Wesleyan University, Department of Economics.
    16. Diamond, D.W. & Kashyap, A.K., 2016. "Liquidity Requirements, Liquidity Choice, and Financial Stability," Handbook of Macroeconomics, in: J. B. Taylor & Harald Uhlig (ed.), Handbook of Macroeconomics, edition 1, volume 2, chapter 0, pages 2263-2303, Elsevier.
    17. Eduardo Dávila & Ansgar Walther, 2021. "Corrective Regulation with Imperfect Instruments," NBER Working Papers 29160, National Bureau of Economic Research, Inc.
    18. Ansgar Walther, 2016. "Jointly Optimal Regulation of Bank Capital and Liquidity," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 48(2-3), pages 415-448, March.
    19. Roberts, Daniel & Sarkar, Asani & Shachar, Or, 2023. "Liquidity regulations, bank lending and fire-sale risk," Journal of Banking & Finance, Elsevier, vol. 156(C).
    20. DeAngelo, Harry & Stulz, René M., 2015. "Liquid-claim production, risk management, and bank capital structure: Why high leverage is optimal for banks," Journal of Financial Economics, Elsevier, vol. 116(2), pages 219-236.

    More about this item

    Keywords

    ;
    ;
    ;
    ;

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D6 - Microeconomics - - Welfare Economics

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:ecb:ecbwps:20263252. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Official Publications (email available below). General contact details of provider: https://edirc.repec.org/data/emieude.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.