Capital and liquidity in a dynamic model of banking

This paper analyzes capital requirements in combination with a particular kind of cash reserves, that are invested in the risk-free asset, from now on, compensated reserves. We consider a dynamic framework of banking where competition may induce banks to gamble. In this set up, we can capture the two effects that capital regulation has on risk, the capital-at-risk effect and the franchise value effect (Hellman et al., 2000). We show that while capital alone is an inferior policy, compensated reserves, will complement capital requirements, by creating franchise value, and are therefore efficient in solving moral hazard problems.