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Bank regulation under fire sale externalities

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  • Gazi Kara
  • S. Mehmet Ozsoy

Abstract

This paper examines the optimal design of and interaction between capital and liquidity regulations in a model characterized by fire sale externalities. In the model, banks can insure against potential liquidity shocks by hoarding sufficient precautionary liquid assets. However, it is never optimal to fully insure, so realized liquidity shocks trigger an asset fire sale. Banks, not internalizing the fire sale externality, overinvest in the risky asset and underinvest in the liquid asset in the unregulated competitive equilibrium. Capital requirements can lead to less severe fire sales by addressing the inefficiency and reducing risky assets -- however, we show that banks respond to stricter capital requirements by decreasing their liquidity ratios. Anticipating this response, the regulator preemptively sets capital ratios at high levels. Ultimately, this interplay between banks and the regulator leads to inefficiently low levels of risky assets and liquidity. Macroprudential liquidity requirements that complement capital regulations, as in Basel III, restore constrained efficiency, improve financial stability and allow for a higher level of investment in risky assets.

Suggested Citation

  • Gazi Kara & S. Mehmet Ozsoy, 2016. "Bank regulation under fire sale externalities," Finance and Economics Discussion Series 2016-026, Board of Governors of the Federal Reserve System (US).
  • Handle: RePEc:fip:fedgfe:2016-26
    DOI: 10.17016/FEDS.2016.026
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    File URL: http://www.federalreserve.gov/econresdata/feds/2016/files/2016026pap.pdf
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    References listed on IDEAS

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    Cited by:

    1. repec:bis:bisbps:95 is not listed on IDEAS
    2. Paul Pichler & Flora Lutz, 2017. "Liquidity risk and financial stability regulation," Vienna Economics Papers 1701, University of Vienna, Department of Economics.
    3. Anil K. Kashyap & Dimitrios P. Tsomocos & Alexandros Vardoulakis, 2017. "Optimal Bank Regulation in the Presence of Credit and Run Risk," Finance and Economics Discussion Series 2017-097, Board of Governors of the Federal Reserve System (US).
    4. Gazi Kara, 2016. "Bank Capital Regulations Around the World : What Explains the Differences?," Finance and Economics Discussion Series 2016-057, Board of Governors of the Federal Reserve System (US).
    5. Bachmann, Manuel, 2018. "The Impact of Ex Ante Regulations and Ex Post Interventions on Bank Lending and Solvency," Department of Economics Working Paper Series 6453, WU Vienna University of Economics and Business.
    6. Adi Mordel, 2018. "Prudential Liquidity Regulation in Banking-A Literature Review," Discussion Papers 18-8, Bank of Canada.
    7. Manuel Bachmann, 2018. "The Impact of Ex Ante Regulations and Ex Post Interventions on Bank Lending and Solvency," Department of Economics Working Papers wuwp269, Vienna University of Economics and Business, Department of Economics.
    8. Bonner, Clemens & Wedow, Michael & Budnik, Katarzyna & Koban, Anne & Kok, Christoffer & Laliotis, Dimitrios & Meller, Barbara & Melo, Ana Sofia & Moldovan, Iulia & Schmitz, Stefan & Couaillier, Cyril , 2018. "Systemic liquidity concept, measurement and macroprudential instruments," Occasional Paper Series 214, European Central Bank.

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    Keywords

    Bank capital regulation ; liquidity regulation ; fire sale externality ; Basel III;

    JEL classification:

    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • 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

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