Liquidity Regulation and Bank Risk Taking on the Horizon

Abstract

We examine how banks' liquidity requirements affect their incentives to take risk with their remaining illiquid assets. Our model predicts that banks with more stable liabilities are more likely to engage in risk taking in response to tighter liquidity requirements. This prediction is borne out in transaction-level data on corporate and mortgage loans for U.S. banks subject to the liquidity coverage ratio (LCR). For identification, we exploit variation in long-term bank bonds held by insurance companies that are not affected by the LCR. Our results point to a trade-off between bank risk taking and ensuring funding resilience over different horizons.

Keywords: liquidity regulation, bank risk taking, insurance sector, LCR, NSFR

JEL Classification: G20, G21, G22, G28