In early April, the Federal Reserve Board’s Divisions of Research and Statistics and Monetary Affairs released a staff working paper entitled “Bank Regulation under Fire Sale Externalities,” addressing the optimal design of, and interaction between, capital and liquidity regulations in a model characterized by fire sale externalities. In particular, the authors analyze whether it suffices to introduce capital regulations alone and let banks freely choose their liquidity ratios or whether liquidity also needs to be regulated. The results of the study indicate that the pre-Basel III regulatory framework, with its reliance only on capital requirements, was inefficient and ineffective in addressing systemic instability caused by fire sales. The paper notes that capital requirements can lead to less severe fire sales by forcing banks to reduce risky assets, however, it also shows that banks respond to stricter capital requirements by decreasing their liquidity ratios. Anticipating this response, the regulator preemptively sets capital ratios at high levels and ultimately, this interplay between banks and the regulator leads to inefficiently low levels of risky assets and liquidity. The paper concludes that macroprudential liquidity requirements that complement capital regulations, as in Basel III, restore constrained efficiency, improve financial stability and allow for a higher level of investment in risky assets.
The Federal Reserve Board staff working paper is available at: http://www.federalreserve.gov/econresdata/feds/2016/files/2016026pap.pdf.