Bank Runs, Prudential Tools and Social Welfare in a Global Game General Equilibrium Model

Abstract

The regulatory framework of Basel III features joint requirements on bank capital and liquidity. I study such requirements by developing a general equilibrium model with bank runs in a global game framework. The model highlights the role of noisy information for studying liquidity and shows that bank runs are inevitable. Risk shifting induces excessive leverage and insufficient liquidity, causing an inefficiently high crisis probability. Imposing one requirement only causes risk migration: banks respond by taking more risk in another area, which warrants joint requirements. The design of the optimal joint requirements depends crucially on the model's general equilibrium effect.