Liquidity provision and optimal bank regulation


  • We thank two anonymous referees and an Editor of the Journal for most valuable comments on an earlier draft. Shy thanks the Aharon Meir Center for Banking at Bar-Ilan University for financial support. Stenbacka thanks RUESG (University of Helsinki) and The Yrjö Jahnsson Foundation for financial support.


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.