Macroprudential Regulation and Banks’ Supply of Liquidity Services

Are banks safer when they hold more safe assets? This paper builds a model in which banks supply liquidity services through uninsured deposits. Define a safe asset as an asset with both low payoff risk and high pledgeability. Banks consider equity costly and because of safe assets’ low payoff risk prefer to fund them largely with deposits. High pledgeability makes this feasible. The rise in banks’ deposit supply increases deposit rates and forces banks to deviate from socially desirable levels of capital to meet return-on-equity targets. Regulatory leverage ratios can be tightened to increase welfare.