A Theory of Bank Liquidity Requirements

Abstract

We develop a theory of bank liquidity (cash reserve) requirements. Because cash is both observable and riskless, greater cash holdings improve bank incentives to manage risk in the remaining, non-cash portfolio of risky assets. In a model with a single bank, cash is held voluntarily to stem depositors' incentives to withdraw funds early in response to adverse news. In a model with multiple banks and information externalities, deposit insurance may be optimal, and cash reserve requirements are needed to incentivize prudent behavior by banks. In a model with multiple banks subject to liquidity shocks, an interbank market can emerge as long as the group of banks imposes a cash requirement to prevent free riding on interbank liquidity assistance. Our theory has several implications for the design of liquidity regulation that are absent from existing regulatory initiatives.