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Keywords:

  • banking regulation;
  • liquidity;
  • reserve requirement;
  • narrow banking
  • G21;
  • G28

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.