September 2017

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.

Accessible materials (.zip)

Keywords: bank runs, capital, credit risk, limited liability, liquidity, regulation


PDF: Full Paper

Back to Top
Last Update: January 09, 2020