A Theory of Bank Liquidity Requirements

Abstract We propose an asset-side theory of bank liquidity requirements. This theory makes three main points. First, on risk-management incentives in banks: Holding cash, especially in adverse economic conditions, enhances a banker's incentive to manage the risk of loans. Without such cash reserves, external investors would be unwilling to invest in the bank. Second, on welfare improvements through liquidity regulation: Banks tend to hold insufficient cash from a social perspective because they individually underestimate the cost of raising cash later through loan sales. These sales occur at fire-sale prices because potential buyers (arbitrageurs) have limited funds. Third, on complementary regulations: Liquidity regulation should be paired with measures that limit the banking sector's size, such as capital requirements. The financial sector collectively underestimates the cost of raising cash ex post. Higher welfare is achieved when arbitrageurs invest their limited funds in areas other than buying loans from banks. Our theory offers new insights for designing liquidity regulations that are not reflected in current regulatory practices. Joint paper with Charles Calomiris, Madalen Castells-Jauregui and Marie Hoerova.