Finance and Economics Discussion Series (FEDS)
Optimal Bank Regulation in the Presence of Credit and Run Risk
Anil K. Kashyap, Dimitrios P. Tsomocos, and Alexandros P. Vardoulakis
We modify the Diamond and Dybvig (1983) model of banking to jointly study various regulations in the presence of credit and run risk. Banks choose between liquid and illiquid assets on the asset side, and between deposits and equity on the liability side. The endogenously determined asset portfolio and capital structure interact to support credit extension, as well as to provide liquidity and risk-sharing services to the real economy. Our modifications create wedges in the asset and liability mix between the private equilibrium and a social planner's equilibrium. Correcting these distortions requires the joint implementation of a capital and a liquidity regulation.
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Keywords: bank runs, capital, credit risk, limited liability, liquidity, regulation
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