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Board of Governors of the Federal Reserve System (U.S.)
Finance and Economics Discussion Series
Bank Liquidity and Capital Regulation in General Equilibrium
Francisco Covas
John C. Driscoll
Abstract

We develop a nonlinear dynamic general equilibrium model with a banking sector and use it to study the macroeconomic impact of introducing a minimum liquidity standard for banks on top of existing capital adequacy requirements. The model generates a distribution of bank sizes arising from differences in banks' ability to generate revenue from loans and from occasionally binding capital and liquidity constraints. Under our baseline calibration, imposing a liquidity requirement would lead to a steady-state decrease of about 3 percent in the amount of loans made, an increase in banks' holdings of securities of at least 6 percent, a fall in the interest rate on securities of a few basis points, and a decline in output of about 0.3 percent. Our results are sensitive to the supply of safe assets: the larger the supply of such securities, the smaller the macroeconomic impact of introducing a minimum liquidity standard for banks, all else being equal. Finally, we show that relaxing the liquidity requirement under a situation of financial stress dampens the response of output to aggregate shocks.


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Francisco Covas & John C. Driscoll, Bank Liquidity and Capital Regulation in General Equilibrium, Board of Governors of the Federal Reserve System (U.S.), Finance and Economics Discussion Series 2014-85, 12 Sep 2014.
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Keywords: Bank regulation; liquidity requirements; capital requirements; incomplete markets; idiosyncratic risk; macroprudential policy
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