How Should Bank Liquidity be Regulated?*

Before the crisis, bank regulation relied to a large extent on capital regulation. Liquidity regulation was not widely used. The liquidity problems during the crisis led to calls for liquidity regulation. As a result, the Basel III accord introduced global liquidity standards. An important issue in the construction of such liquidity regulations is the exact nature of the problem they are trying to solve. What is the market failure they are designed to correct? Why is the provision of liquidity that the market provides insufficient? This paper considers the literature analyzing liquidity regulation. There is no wide agreement on the rationale for liquidity regulation. * Franklin Allen is Professor of Finance and Economics, and Director of the Brevan Howard Centre at Imperial College London. Douglas Gale is Silver Professor and Professor of Economics at New York University. The paper was prepared for the Federal Reserve Bank of Chicago and the European Central Bank’s co-sponsored 2016 International Banking Conference. We are grateful for comments from Douglas Diamond.