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Liquidity provision and optimal bank regulation

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  • Oz Shy
  • Rune Stenbacka

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.

Suggested Citation

  • Oz Shy & Rune Stenbacka, 2007. "Liquidity provision and optimal bank regulation," International Journal of Economic Theory, The International Society for Economic Theory, vol. 3(3), pages 219-233, September.
    • Handle: RePEc:bla:ijethy:v:3:y:2007:i:3:p:219-233
    DOI: 10.1111/j.1742-7363.2007.00057.x
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    References listed on IDEAS

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    1. Ron J. Feldman & Arthur J. Rolnick, 1998. "Fixing FDICIA: a plan to address the too-big-to-fail problem," Annual Report, Federal Reserve Bank of Minneapolis, vol. 12(Mar), pages 2-22.
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    1. repec:zbw:bofrdp:2015_023 is not listed on IDEAS
    2. Shi Chen & Jeng-Yan Tsai & Rosemary Jou, 2016. "Equities of scope as merger incentives under capital regulation: narrow versus synergy banking valuation," Applied Economics, Taylor & Francis Journals, vol. 48(37), pages 3508-3525, August.
    3. repec:zbw:bofrdp:urn:nbn:fi:bof-201511261452 is not listed on IDEAS
    4. Shy, Oz & Stenbacka, Rune, 2017. "An overlapping generations model of taxpayer bailouts of banks," Journal of Financial Stability, Elsevier, vol. 33(C), pages 71-80.
    5. Mariotto, Carlotta & Verdier, Marianne, 2015. "Innovation and competition in Internet and mobile banking: an industrial organization perspective," Bank of Finland Research Discussion Papers 23/2015, Bank of Finland.
    6. Mariotto, Carlotta & Verdier, Marianne, 2015. "Innovation and competition in Internet and mobile banking: an industrial organization perspective," Research Discussion Papers 23/2015, Bank of Finland.
    7. Carlotta MARIOTTO & Marianne VERDIER, 2015. "Innovation and Competition in Internet and Mobile Banking: an Industrial Organization Perspective," Communications & Strategies, IDATE, Com&Strat dept., vol. 1(99), pages 129-146, 3rd quart.
    8. repec:bof:bofrdp:urn:nbn:fi:bof-201511261452 is not listed on IDEAS

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