Working Paper

Bank Liquidity and Capital Regulation in General Equilibrium

Abstract: We develop a nonlinear dynamic general equilibrium model with a banking sector and use it to study the macroeconomic impact of introducing a minimum liquidity standard for banks on top of existing capital adequacy requirements. The model generates a distribution of bank sizes arising from differences in banks' ability to generate revenue from loans and from occasionally binding capital and liquidity constraints. Under our baseline calibration, imposing a liquidity requirement would lead to a steady-state decrease of about 3 percent in the amount of loans made, an increase in banks' holdings of securities of at least 6 percent, a fall in the interest rate on securities of a few basis points, and a decline in output of about 0.3 percent. Our results are sensitive to the supply of safe assets: the larger the supply of such securities, the smaller the macroeconomic impact of introducing a minimum liquidity standard for banks, all else being equal. Finally, we show that relaxing the liquidity requirement under a situation of financial stress dampens the response of output to aggregate shocks.

Keywords: Bank regulation; liquidity requirements; capital requirements; incomplete markets; idiosyncratic risk; macroprudential policy;

JEL Classification: D52; E13; G21; G28;

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2014-09-12

Number: 2014-85

Pages: 39 pages