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Macroeconomics of Bank Capital and Liquidity Regulations

We study the transmission mechanisms of liquidity and capital regulations as well as their effects on the economy and welfare. We propose a macro-economic model in which a regulator faces the following trade-off. On the one hand, banking regulations may reduce the aggregate supply of credit. On the other hand, they promote the allocation of credit to its best uses. Accordingly, in a regulated economy there is less, but more productive lending. Based on a version of the model calibrated on US data, we find that both liquidity and capital requirements are needed, and must be set relatively high. They also mutually reinforce each other, except when liquid assets are scarce. Our analysis thus provides broad support for Basel III's "multiple metrics" framework.