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Enough Liquidity with Enough Capital—and Vice Versa?

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  • Gersbach, Hans
  • Haller, Hans
  • Zelzner, Sebastian

Abstract

We study the interplay of capital and liquidity regulation in a general equilibrium setting by focusing on future funding risks. The model consists of a banking sector with long-term illiquid investment opportunities that need to be financed by short-term debt and by issuing equity. Reliance on refinancing long-term investment in the middle of the life-time is risky, since the next generation of potential short-term debt holders may not be willing to provide funding when the return prospects on the long-term investment turn out to be bad. For moderate return risk, equilibria with and without bank default coexist, and bank default is a self-fulfilling prophecy. Capital and liquidity regulation can prevent bank default and may implement the first-best. Yet the former is more powerful in ruling out undesirable equilibria and thus dominates liquidity regulation. Adding liquidity regulation to optimal capital regulation is redundant.

Suggested Citation

  • Gersbach, Hans & Haller, Hans & Zelzner, Sebastian, 2024. "Enough Liquidity with Enough Capital—and Vice Versa?," CEPR Discussion Papers 19072, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:19072
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    More about this item

    Keywords

    Financial intermediation; Funding risk; Bank default; Banking regulation; Liquidity requirements; Capital requirements;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
    • G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation

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