Getting the Right Mix of Capital and Cash Requirements in Prudential Bank Regulation*

Abstract

Cash reserve requirements are useful as a broadly conceived prudential tool, not just as a narrowly focused means of limiting the risks associated with illiquidity. Indeed, illiquidity risk is neither a necessary nor a sufficient condition for establishing bank liquidity requirements. The primary means of mitigating the systemic costs of bank illiquidity risk is the creation of an effective lender of last resort (LOLR). But instead of focusing narrowly on bank funding risks when designing liquidity requirements, regulators should consider tradeoffs among capital requirements, liquidity requirements, and LOLR policies for achieving the broader prudential goal of limiting bank default risk.When considering the optimal tradeoff between capital ratios and cash ratios as prudential requirements, five “frictions” are identified that favor the use of one or the other: (1) the adverse‐selection costs of raising equity (which favors the use of cash); (2) the opportunity cost of forgone abnormal profits (or “quasi rents”) from lending (which favors the use of capital); (3) the limited verifiability of loan outcomes (which favors the use of cash); (4) the moral hazard that results from costly or postponed loss recognition, given the incentive for risk shifting in bad states (which favors the use of cash); and (5) the prospect of changes in the risk environment (which favors cash since it creates greater option value for maintaining targeted default risk with lower adjustment costs in the face of changing loan risk or illiquidity risk).When viewed from the perspective of achieving the main prudential goal of controlling default risk at a minimum social cost, capital requirements have some limitations that favor liquidity requirements, and vice versa. And thus the optimal regulatory policy will combine liquidity and capital requirements.