The effects of capital and liquidity regulations on banks

This dissertation includes three essays on Basel III. Basel III is considered as the most comprehensive set of regulations for mitigating banks' credit risk and market risk. Its major function is to encourage banks to raise more capital and carry sufficient liquid assets to avoid bank runs and defend against financial crises, thus promoting the stability of the financial system and maximizing the social warfare. Although stricter capital and liquidity requirements reduce the risk of bank runs, a voice of opposition about the negative impact of the regulations on banks' lending and profitability exists all the time. Finance researchers have conducted a number of theoretical and empirical studies to investigate how rigorous regulations affect the banks' risk and performance. The first essay in this dissertation summarizes this growing literature and sheds light on the future research areas on how capital and liquidity requirements in Basel III affect Banks' lending and performance. The second essay expands the classic Diamond and Dybvig model of banking. In this new model, households can not only deposit in a bank but also directly invest in the bank's equity. In addition, the asset portfolio of the bank has an effect on the probability of a bank run. This new model helps us to explore how to find the "effective ranges" of capital and liquidity regulations, in which the bank-run probability declines from the original level. The paper also discusses how capital and liquidity regulations change behaviors of banks and households. Compared with the liquidity requirement, the capital requirement has only a slight impact on the social welfare. In the third essay, I develop a general equilibrium model with banks of heterogeneous size to study optimal capital and liquidity requirements. I first show that when only a capital requirement is available, the optimal policy is size-dependent: larger banks face stricter capital requirements. If regulations must instead be size-independent, I show that introducing a liquidity requirement can raise welfare. This result arises because a capital requirement is more likely to bind in small banks, while a liquidity requirement tends to bind in large banks. I derive the optimal size-independent policy pair and show how the regulator uses the two policies to affect large and small banks differently. My results provide a novel justification for liquidity requirements: they interact with capital requirements to provide a regulator more flexibility.Ph.D.Includes bibliographical reference