Capital and Liquidity Interaction in Banking

50 Pages Posted: 24 Dec 2019 Last revised: 23 Jun 2020

See all articles by Jonathan Acosta Smith

Jonathan Acosta Smith

Bank of England

Guillaume Arnould

Université Paris I Panthéon-Sorbonne - Centre d'Economie de la Sorbonne (CES); Bank of England

Kristoffer Milonas

Bank of England

Quynh-Anh Vo

Bank of England

Date Written: December 20, 2019

Abstract

We study how banks’ capital level affects the extent to which they engage in liquidity transformation. We first construct a simple model to develop testable hypotheses on this link. Then we test our predictions and establish the causality using a confidential Bank of England dataset that includes arguably exogenous changes in banks’ capital requirement add-ons. We find that banks engage in less liquidity transformation when their capital increases, which suggests that capital and liquidity requirements are at least to some extent substitutes. We also find that this substitution is mostly driven by small banks. These results have interesting implications for the optimal joint calibration of capital and liquidity requirements and for the proportionality of prudential regulations.

Keywords: banking, liquidity transformation, capital requirements and financial regulation

JEL Classification: G21, G28, G32

Suggested Citation

Acosta Smith, Jonathan and Arnould, Guillaume and Arnould, Guillaume and Milonas, Kristoffer and Vo, Quynh Anh, Capital and Liquidity Interaction in Banking (December 20, 2019). Bank of England Working Paper No. 840, December 2019, Available at SSRN: https://ssrn.com/abstract=3508662 or http://dx.doi.org/10.2139/ssrn.3508662

Jonathan Acosta Smith (Contact Author)

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Guillaume Arnould

Université Paris I Panthéon-Sorbonne - Centre d'Economie de la Sorbonne (CES) ( email )

106-112 Boulevard de l'hopital
106-112 Boulevard de l'Hôpital
Paris Cedex 13, 75647
France

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Kristoffer Milonas

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Quynh Anh Vo

Bank of England ( email )

20 Moorgate
London, EC2R 6DA
United Kingdom

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