The Costs and Benefits of Liquidity Regulations: Lessons from an Idle Monetary Policy Tool

Abstract We investigate how liquidity regulations affect banks by examining a dormant monetary policy tool that functions as a liquidity regulation. For causal inference, we use a regression kink design that relies on the variation in a marginal high-quality liquid asset requirement around an exogenous threshold. We show that mandated increases in liquidity cause banks to reduce credit supply. Liquidity requirements also depress banks’ profitability, though some of the regulatory costs are passed on to liability holders. We document a prudential benefit of liquidity requirements by showing that banks subject to a higher requirement just before the financial crisis had lower odds of failure.