Bank Capital, Liquid Reserves, and Insolvency Risk
45 Pages Posted: 11 Jun 2014 Last revised: 13 Aug 2016
Date Written: August 11, 2016
We develop a dynamic model of banking to assess the effects of liquidity and leverage requirements on banks' insolvency risk. In this model, banks face taxation, flotation costs of securities, and default costs and maximize shareholder value by making their financing, liquid asset holdings, and default decisions in response to these frictions as well as regulatory requirements. Our analytic characterization of the bank policy choices shows that imposing solely liquidity requirements leads to lower bank losses in default at the cost of an increased likelihood of default. Combining liquidity requirements with leverage requirements reduces drastically both the likelihood of default and the magnitude of bank losses in default.
Keywords: banks; liquidity buffers; capital structure; insolvency risk; regulation
JEL Classification: G21, G28, G32, G33
Suggested Citation: Suggested Citation