Capital Adequacy and Liquidity in Banking Dynamics: Theory and Regulatory Implications

We present a framework for modelling optimum capital adequacy in a dynamic banking context. We combine the (static) capital adequacy framework of Repullo (2013) with a dynamic banking model similar to that of Corbae and D`Erasmo (2014), with the extra feature that the probability of systemic risk is endogenous. Unlike previous work, we examine frameworks to ameliorate bankruptcy using both capital adequacy and liquidity requirements. Since equity is costly, the social cost of regulation may be reduced if a regulatory capital requirement can be accompanied by other tools such as a liquidity buffer.