The different roles of liquidity and capital in preventing financial crises: insights from a Post-Keynesian model

This paper extends the Post-Keynesian analysis of bank regulation by using a small-scale macro model with banking to examine the operation of macroprudential regulation for the prevention of financial crises. Macroprudential regulation operates in this model by affecting bank funding costs, the pricing of bank loans, demand for assets, and asset price inflation. Because this type of regulation targets asset bubbles directly, it constitutes a better instrument than monetary policy for addressing the build-up of systemic risk without the negative consequences that higher interest rates have for income distribution. It is shown that capital requirements are an effective instrument of such macroprudential policy but that tighter liquidity requirements work in the wrong direction. It is argued, however, that liquidity has an important defensive role to play in prudential regulation by reducing the likelihood of depositor withdrawals when bubbles burst or some other shock reduces the value of bank loans.