Investor Demands for Safety, Bank Capital, and Liquidity Measurement

45 Pages Posted: 28 Sep 2020

See all articles by S. Wayne Passmore

S. Wayne Passmore

Board of Governors of the Federal Reserve System

Judit Temesvary

Board of Governors of the Federal Reserve System

Date Written: September, 2020

Abstract

We construct a model of a bank's optimal funding choice, where the bank negotiates with both safety-driven short-term bondholders and (mostly) risk-taking long-term bondholders. We establish that investor demands for safety create a negative relationship between the bank's capital choices and short-term funding, as well as negative relationships between capital and common measures of bank liquidity. Consistent with our model, our bank-level empirical analysis of these capital-liquidity tradeoffs show (1) that bank liquidity measures have a strong and negative relationship to its capital ratio for both large and small banks, and (2) that this relationship has weakened with the advent of stronger liquidity regulation. Our results suggest that the safety concerns of bank debt investors may underlie capital-liquidity tradeoffs and that a bank's share of collateralized short-term debt may be a more robust measure of bank liquidity.

Keywords: Safe assets, Bank liquidity, Liquidity regulation, Capitalization, Bank balance sheet management

JEL Classification: G11, G18, G21, G23, G28

Suggested Citation

Passmore, Stuart Wayne and Temesvary, Judit, Investor Demands for Safety, Bank Capital, and Liquidity Measurement (September, 2020). FEDS Working Paper No. 2020-079, Available at SSRN: https://ssrn.com/abstract=3699643 or http://dx.doi.org/10.17016/FEDS.2020.079

Stuart Wayne Passmore (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States
202-452-6432 (Phone)
202-452-3819 (Fax)

Judit Temesvary

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States
202-452-3759 (Phone)

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