Liquidity requirement and banks' lending

This study proposes a model that describes banks' decisions about how much liquidity they hold and analyzes how liquidity regulations affect the amount of their lending. In literature, it is pointed out that banks are likely to hold ex-post excess liquidity under a liquidity regulation when some depositors make decisions based on the banks' soundness. This result implies that the regulation forces banks to suffer an unnecessary decrease of their lending, and thus, they would try to mitigate the loss by adjusting their portfolio. The aim of this study is to investigate whether banks' lending decreases or not when there exist multiple sets of assets that satisfy a liquidity regulation. In addition, we analyze two types of liquidity regulation; one focuses on banks' survivability, and the other focuses on continuity of their liquidity holding. The model shows that, even when there exist other ways to satisfy the regulations besides holding only reserves, banks still hold an ex-post excess amount of liquidity under either type of liquidity regulation. However, the model also shows that the amount of banks' lending varies according to how they satisfy the liquidity regulation and the probability that a severe reduction of lending happens depends partly on the regulation's type. These results implies that banks' decisions for mitigating losses caused by liquidity regulations lead to an undesired outcome, and thus, we consider more carefully banks' decisions under liquidity regulations.