The Interdependence of Bank Capital and Liquidity

This paper analyzes the role of liquidity regulation and its interaction with capital requirements. We first introduce costly capital in a bank run model with endogenous bank portfolio choice and run probability, and show that capital regulation is the only way to restore the efficient allocation. We then enrich the model to include fire sales, and show that capital and liquidity regulation are complements. The key implications of our analysis are that the optimal regulatory mix should be designed considering both sides of banks' balance sheet, and that its effectiveness depend on the costs of both capital and liquidity.