Capital and Liquidity Interaction in Banking

Abstract

We study how banks’ capital levels affect the extent to which banks engage in liquidity transformation. We first build a simple model to develop a testable hypothesis of this relationship. We then test our prediction using a confidential Bank of England dataset that includes time varying and arguably exogenous add-ons to banks’ capital requirements. We find that, on average, banks engage in less liquidity transformation when their capital increases, which suggests that capital and liquidity requirements are, to at least some extent, substitutes. We also find that this substitution is mostly driven by smaller 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 and Capital Requirements