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Board of Governors of the Federal Reserve System (US)
Finance and Economics Discussion Series
Bank regulation under fire sale externalities
Gazi Kara
S. Mehmet Ozsoy

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.

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Gazi Kara & S. Mehmet Ozsoy, Bank regulation under fire sale externalities, Board of Governors of the Federal Reserve System (US), Finance and Economics Discussion Series 2016-026, Mar 2016.
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Keywords: Bank capital regulation ; liquidity regulation ; fire sale externality ; Basel III
DOI: 10.17016/FEDS.2016.026
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