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Liquidity provision and optimal bank regulation
Author(s) -
Shy Oz,
Stenbacka Rune
Publication year - 2007
Publication title -
international journal of economic theory
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.351
H-Index - 11
eISSN - 1742-7363
pISSN - 1742-7355
DOI - 10.1111/j.1742-7363.2007.00057.x
Subject(s) - market liquidity , shock (circulatory) , monetary economics , investment (military) , economics , welfare , liquidity risk , function (biology) , liquidity crisis , selection (genetic algorithm) , accounting liquidity , set (abstract data type) , business , microeconomics , market economy , medicine , evolutionary biology , artificial intelligence , politics , political science , law , computer science , biology , programming language
We extend the set of regulatory instruments for banks' liquidity provision by adding a policy instrument for controlling the fraction of perfectly‐liquid accounts. We demonstrate how this instrument induces self‐selection on behalf of depositors who are differentiated according to their probability of facing a liquidity shock. This self‐selection leads to a market segmentation, which can break the bundling of deposits with liquidity risk and, thereby, enhance welfare. The optimal regulatory policy is explicitly characterized as a function of banks' investment return, and of depositors' gain from early withdrawals to fund a realized investment opportunity.