Liquidity provision and optimal bank regulation |
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| Authors: | Oz Shy Rune Stenbacka |
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| Institution: | WZB –Social Science Research Center, Berlin, Germany, and University of Haifa, Haifa, Israel. Email: . From mid-July: Department of Economics, University of Michigan, Ann Arbor, USA.;Swedish School of Economics, Helsinki, Finland, and Department of Economics, Göteborg University, Göteborg, Sweden. |
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| Abstract: | We extend the set of regulatory instruments for banks' liquidity provision by adding a policy instrument for controlling the fraction of perfectly-liquid accounts. We demonstrate how this instrument induces self-selection on behalf of depositors who are differentiated according to their probability of facing a liquidity shock. This self-selection leads to a market segmentation, which can break the bundling of deposits with liquidity risk and, thereby, enhance welfare. The optimal regulatory policy is explicitly characterized as a function of banks' investment return, and of depositors' gain from early withdrawals to fund a realized investment opportunity. |
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| Keywords: | banking regulation liquidity reserve requirement narrow banking |
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