Bank regulation under fire sale externalities ∗ Gazi

This paper examines the optimal design of capital and liquidity regulations under fire sale externalities. The lack of complementary liquidity ratio requirements harms the purpose of capital adequacy requirements by yielding not only inefficiently low risky investment but also more severe financial crises. When capital is regulated but liquidity is not, banks still keep liquid assets for micro-prudential reasons because they can use these resources to protect against liquidity shocks. However, liquidity has also macro-prudential effects: Higher liquidity holdings lead to less severe decreases in asset prices during distress times; but this externality is not internalized by individual banks. Therefore, the liquidity holdings of banks are inefficiently low from a social point of view. Predicting this reaction of banks, the regulator raises the minimum capital ratio requirement to inefficiently high levels, which results in some socially profitable projects also end up being unfunded. We also show that banks hold less liquid assets compared to the competitive equilibrium when only capital ratio is regulated. There are two ways through which banks can get exposed to fire sale risk: holding excess risky asset and not holding enough liquidity. When the first option is limited by the capital regulation, banks use the second option in order to get closer to their privately optimal level of risk. Our results indicate that the regulatory framework in the pre-Basel III period, which predominantly focused on capital adequacy requirements, was both inefficient and ineffective in addressing systemic instability caused by fire sales. ∗The analysis and the conclusions set forth are those of the authors and do not indicate concurrence by other members of the research staff or the Board of Governors of the Federal Reserve. †Contact author: Office of Financial Stability Policy and Research, Board of Governors of the Federal Reserve System. 20th Street and Constitution Avenue N.W. Washington, D.C. 20551. Email: [email protected] ‡Ozyegin University, Istanbul, Turkey. Email: [email protected]