Discussion paper

DP14055 Insolvency-Illiquidity, Macro Externalities and Regulation

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.


Faia, E (2019), ‘DP14055 Insolvency-Illiquidity, Macro Externalities and Regulation‘, CEPR Discussion Paper No. 14055. CEPR Press, Paris & London. https://cepr.org/publications/dp14055