Financial Stability Workshop - A Theory of Bank Liquidity Requirements

Résumé

We develop an asset-side theory of bank liquidity requirements, which focuses on the risk-management gains from requiring cash reserves. The key role of cash in the bank is to attenuate the banker’s moral hazard. Because cash is observable and riskless, its value does not depend on the banker’s risk management effort. Greater cash holding improves bank incentives to manage risk in the remaining, non-cash, portfolio of risky assets. Because cash is ring-fenced from moral hazard, it serves as a form of collateral to bank creditors. We allow cash to be generated either initially from the funding of the bank or subsequently by selling risky assets in the market. But buyers of risky assets have limited aggregate resources, which generates a fire-sale discount on risky assets sold by the bank to generate cash. The fire-sale externality leads to a wedge between privately-optimal and socially-optimal liquidity holdings, requiring regulation of bank cash holdings to address the externality. More equity capital ex ante also improves risk management incentives but cash can be complementary to equity because it can be generated in the bad state, at the time when it is hard or impossible for a bank to raise more equity. Our theory has several implications for the design of liquidity regulation that are absent from existing regulation.

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