The Effect of Liquidity Regulation on U.S. Bank Risk-Taking: Evidence from Non-Performing Loans and CDS Spreads

57 Pages Posted: 2 Apr 2020 Last revised: 14 Jul 2020

See all articles by Joshua Bosshardt

Joshua Bosshardt

Massachusetts Institute of Technology (MIT)

Ali Kakhbod

Rice University

Date Written: March 9, 2020

Abstract

This paper illustrates channels by which regulations that require banks to hold liquid assets can either increase or decrease a bank’s incentive to take risk with its remaining ineligible assets. A greater capacity to respond to liquidity stress increases the potential profits a bank would put at stake by making risky investments, but it also mitigates the illiquidity disadvantages of holding risky assets. We then empirically estimate the effect of two liquidity regulations on bank risk-taking as measured by the ratio of non-performing loans to total loans and credit default swap (CDS) spreads. Using a regression discontinuity design, we do not find evidence that reserve requirements significantly affected non-performing loans ratios. Using a difference- in-differences specification, we also do not find evidence that the liquidity coverage ratio significantly affected non-performing loans ratios or CDS spreads.

Keywords: liquidity regulation, bank risk, reserve requirements, liquidity coverage ratio

JEL Classification: G21, G28

Suggested Citation

Bosshardt, Joshua and Kakhbod, Ali, The Effect of Liquidity Regulation on U.S. Bank Risk-Taking: Evidence from Non-Performing Loans and CDS Spreads (March 9, 2020). Available at SSRN: https://ssrn.com/abstract=3550912 or http://dx.doi.org/10.2139/ssrn.3550912

Joshua Bosshardt (Contact Author)

Massachusetts Institute of Technology (MIT) ( email )

77 Massachusetts Avenue
50 Memorial Drive
Cambridge, MA 02139-4307
United States

Ali Kakhbod

Rice University ( email )

6100 South Main Street
Houston, TX 77005-1892
United States

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