Saturday, October 15, 2016: 9:00 AM
We develop a theory of bank liquidity (cash reserve) requirements. The model encompasses three motives for requiring bank cash holdings as part of a prudential regulatory framework: (1) cash is observable and verifiable, (2) because the riskiness of cash is invariant to bankers’ decisions about whether to invest resources in risk management, greater cash holdings improve incentives to manage risk in the non-cash asset portfolio of risky assets held by the bank, and (3) maintaining cash in advance saves on liquidation costs. In an autarkic banking equilibrium, cash is held voluntarily by banks as a commitment device to manage risk properly; increasing cash holdings in response to adverse news stems depositors’ incentives to withdraw funds early. In a model with multiple banks and information externalities, deposit insurance may be optimal, and cash reserve requirements are needed to incentivize prudent behavior by banks. In a model with multiple banks subject to liquidity shocks, the coalition of banks will commit to lend each other funds in response to bank-specific needs to accumulate cash; in that equilibrium, cash requirements will be imposed by the group to prevent free riding on efficient interbank liquidity assistance. Keywords: Liquidity regulation, reserve requirements, bank runs, deposit insurance, moral hazard, risk management
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