Citation

Discussion Paper Details

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Title: Insolvency-Illiquidity, Macro Externalities and Regulation

Author(s): Ester Faia

Publication Date: October 2019

Keyword(s): Basel regimes, equity requirements, information-based bank runs, liquidity requirements, Pecuniary externalities and Ramsey plan

Programme Area(s): Financial Economics, International Macroeconomics and Finance and Monetary Economics and Fluctuations

Abstract: This paper studies the optimal design of equity and liquidity regulations in a dynamic macro model with information-based bank runs. Although the latter are privately efficient, since they discipline bank managers efforts into the projects' re-deploying activity, they induce aggregate externalities. Technological inefficiencies arise if bank managers extract rents which are higher than the technological costs of re-deploying projects. Pecuniary externalities arise since, when choosing leverage, bank managers do not internalize the fall in asset price ensuing from the aggregate costs of projects' liquidation in a run event. This creates scope for regulation. Equity and liquidity requirements are complementary, as the first tackles the solvency region, while the second the illiquid-solvent one. Finally, in presence of anticipatory effects prudential policies may have unintended consequences as banks adjust their behaviour when a shift in prudential regime is announced. The more so the higher the credibility of the announcement.

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Bibliographic Reference

Faia, E. 2019. 'Insolvency-Illiquidity, Macro Externalities and Regulation'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=14055