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The Welfare Effects of Bank Liquidity and Capital Requirements

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  • Skander Van den Heuvel

    (Federal Reserve Board)

Abstract

The stringency of bank liquidity and capital requirements should depend on their social costs and benefits. This paper investigates the welfare effects of these regulations and provides a quantification of their welfare costs. The special role of banks as liquidity providers is embedded in an otherwise standard general equilibrium growth model. In the model, capital and liquidity regulation mitigate moral hazard on the part of banks due to deposit insurance, which, if unchecked, can lead to excessive risk taking by banks through credit or liquidity risk. However, these regulations are also costly because they reduce the ability of banks to create net liquidity and they can distort capital accumulation. For the liquidity requirement, the reason is that safe, liquid assets are necessarily in limited supply and may have competing uses. A key insight is that equilibrium asset returns reveal the strength of preferences for liquidity, and this yields two simple formulas that express the welfare cost of each requirement as a function of observable variables only. Using U.S. data, the welfare cost of a 10 percent liquidity requirement is found to be equivalent to a permanent loss in consumption of about 0.03%. Even using a conservative estimate, the cost of a similarly-sized increase in the capital requirement is about five times as large. At the same time, the financial stability benefits of capital requirements are also found to be broader.

Suggested Citation

  • Skander Van den Heuvel, 2019. "The Welfare Effects of Bank Liquidity and Capital Requirements," 2019 Meeting Papers 325, Society for Economic Dynamics.
  • Handle: RePEc:red:sed019:325
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    File URL: https://economicdynamics.org/meetpapers/2019/paper_325.pdf
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    References listed on IDEAS

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    1. Flannery, Mark J & Sorescu, Sorin M, 1996. " Evidence of Bank Market Discipline in Subordinated Debenture Yields: 1983-1991," Journal of Finance, American Finance Association, vol. 51(4), pages 1347-1377, September.
    2. Emmanuel Farhi & Jean Tirole, 2012. "Collective Moral Hazard, Maturity Mismatch, and Systemic Bailouts," American Economic Review, American Economic Association, vol. 102(1), pages 60-93, February.
    3. Feenstra, Robert C., 1986. "Functional equivalence between liquidity costs and the utility of money," Journal of Monetary Economics, Elsevier, vol. 17(2), pages 271-291, March.
    4. Raj Chetty, 2009. "Sufficient Statistics for Welfare Analysis: A Bridge Between Structural and Reduced-Form Methods," Annual Review of Economics, Annual Reviews, vol. 1(1), pages 451-488, May.
    5. repec:wly:jmoncb:v:49:y:2017:i:1:p:5-37 is not listed on IDEAS
    6. Carlson, Mark A. & Duygan-Bump, Burcu & Nelson, William R., 2015. "Why Do We Need Both Liquidity Regulations and a Lender of Last Resort? A Perspective from Federal Reserve Lending during the 2007-09 U.S. Financial Crisis," Finance and Economics Discussion Series 2015-11, Board of Governors of the Federal Reserve System (US).
    7. Gary Gorton & Tyler Muir, 2016. "Mobile collateral versus immobile collateral," BIS Working Papers 561, Bank for International Settlements.
    8. Gary Gorton & Tyler Muir, 2016. "Mobile Collateral versus Immobile Collateral," NBER Working Papers 22619, National Bureau of Economic Research, Inc.
    9. Juliane Begenau, 2015. "Capital Requirements, Risk Choice, and Liquidity Provision in a Business Cycle Model," 2015 Meeting Papers 687, Society for Economic Dynamics.
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