Bank Signaling, Risk of Runs, and the Informational Impact of Prudential Regulations

Banks can take costly actions (such as higher capitalization, liquidity holding, and advanced risk management) to fend off runs. While such actions directly affect bank risks, they can also serve as signals of the banks’ fundamentals. A separating equilibrium due to such signaling, however, would involve two types of inefficiency: strong banks choose excessively costly signals, whereas weak banks are particularly vulnerable to runs. We show that minimum regulatory requirements can maintain a pooling equilibrium and eliminate the inefficiencies associated with the separation. We support this novel rationale for prudential regulations with evidence from the US liquidity requirement.