by Philipp Johann König
DIW Berlin
This paper shows that bank liquidity regulation may be a "double-edged sword." Under certain conditions, it may hamper, rather than strengthen, a bank's resilience to financial stress. The reason is the existence of two opposing effects of liquidity regulation, a liquidity effect and a solvency effect. The liquidity effect arises because a bank mitigates its risk of illiquidity when it increases its liquidity buffer. The solvency effect arises because a larger liquidity buffer reduces the bank's returns and may therefore raise its insolvency risk. Liquidity regulation is effective in reducing a bank's overall default risk only if the former effect dominates the latter. The paper derives conditions under which this is the case and discusses the resulting relationship between capital and liquidity regulation.
JEL Codes: G21, G28.
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