Liquidity Regulation and Financial Stability

Anticipating a bailout in the event of a crisis distorts a bank's incentives in multiple dimensions. Bailout payments can, for example, lead banks to issue too much short-term debt while simultaneously underinvesting in liquid assets. To correct these distortions, policymakers may choose to regulate the composition of both banks' assets and their liabilities. I examine these regulations in a version of the Diamond-Dybvig (1983) model entailing limited commitment. I demonstrate that, contrary to common wisdom, introducing a minimum liquidity requirement can increase banks' susceptibility to a run by their depositors