Optimal regulation of credit lines

Optimal regulation of credit lines

Series: Working Papers. 2323.

Author: José E. Gutiérrez.

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This paper presents a contract-theoretic model in which banks choose pre-arranged and ex post funding to finance firms’ liquidity needs through credit lines. When liquidity needs are high, pre-arranged funding is key to sustaining lending and reducing the number of firms going into liquidation. Yet, in the presence of a pecuniary externality on firms’ liquidation values, competitive banks choose insufficient pre-funding compared with a constrained social planner. Constrained efficiency can be restored using regulatory liquidity ratios. The optimal regulatory ratio depends on the frequency of high liquidity need conditions, the value lost after a firm’s liquidation, and the premium on pre-funding.

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