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.

This paper investigates the impact of extreme shocks on stock and bond markets on listed European banks. The originality of our approach consists in dealing jointly with stock and bond markets and taking into account their interdependencies in case of extreme events by using a specific CVRF (CVine Risk Factor) model which combines copulas and a factorial structure. Moreover, contrary to what is generally done in the literature, we do not focus only on the responses of the stock returns but we also examine the response of the balance sheets of the banks and particularly of their short term assets in order to assess their fragility in terms of liquidity. Our main findings are the following: 1) the nature of the banks' fragility has changed: today, the interest rate risk should be the first concern before the equity risk, as the banks have extensively increased their exposition to bond market due to flightto-quality reactions and to large investments in governments bonds after the rescue operations the banks have benefited; 2) in case of a surge in the interest rate and in the links between stock and bond returns, the portfolios of the biggest banks in Europe would experience very severe shortfalls for both equity and liquidity buffers. Accordingly regulators should monitor the evolution of dependencies between assets and should pay utmost attention to the positive links between stock and bond returns.