I show that when the banking sector’s assets comprise large excess reserves and loans, jointly determined capital regulation and interest-on-excess-reserves (IOER) policies provide welfare gains. In general equilibrium, falling IOER is associated with a proportional fall in deposit rate only when IOER is above the zero bound. This leads to a faster fall in the bank’s interest expenses than its interest incomes. Given any lending level, lower net interest expenses enhance bank solvency. Nonetheless, the risk-weighted capital regulation remains unchanged and hence becomes socially costly. I show that jointly determined policies achieve welfare gains by loosening the capital requirement and lowering IOER to expand the credit flow, while bank failure likelihood remains constant. Conversely, lowering IOER below the zero bound is associated with a nonresponsive deposit rate that leads to growing net interest expenses and worsening bank solvency. In that case, I show that a stricter capital constraint together with a lower IOER provide social value.

The aftermath of the financial crisis inherited heightened economic uncertainty and low productivity. These features prompted the banking sectors across the developed economies to rely heavily on excess reserves offered by the central banks despite the negative nominal IOER policy rate. Nonetheless, the negative relationship between the overall interest expenses of the banking sector with the IOER around the zero lower bound further exacerbates the over-reliance on excess reserves particularly when rates are negative. Financial regulator faces a trade-off between the costly failure of an under-capitalized banking system and costs generated by interconnections between interest expenses on oversized excess reserves and government guarantees to depositors. I show that first, the risk-weighted optimal capital regulation exhibits a negative correlation with the IOER policy rate, and second present a socially optimal financial regulation that balances the social gains of negative IOER rate, generated by reduced over-reliance on idle reserves, against its social costs, generated by the increased default likelihood of the banking institutions.