Capital and Liquidity Interaction in Banking
50 Pages Posted: 24 Dec 2019 Last revised: 23 Jun 2020
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: Suggested Citation