Capital and Liquidity Interaction in Banking

Abstract

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.

Bank Liquidity Risk and Capital Structure: A Conceptual Review of Theoretical and Empirical Research on Islamic Banking Perspective

“…At the same time, banks hold liquid assets such as cash and securities in order to safe guard against sudden withdrawals by the depositors or commonly known as bank run (Saidbenberg & Strahan, 1999). This is in line with Acosta-Smith et al (2019) where banks need to hold large amount of liquid assets since it is less profitable than illiquid assets. Due to this, it will be fairly costly for a bank with small amount of capital to cover liquidity risk, which encourage the bank to confront with excessive liquidity risk.…”

“…Concerning to this matter, new regulatory liquidity standards have been proposed by Basel Committee on Banking Supervision to complement the new capital framework. It is aiming to improve liquidity requirement in order to avoid from the banks to take an assertive transformation of liquidity which might lead to excessive liquidity risk (Acosta-Smith, Arnould, Milonas & Vo, 2019). As pointed by Diamond and Rajan (2000), increase in bank capital can reduces liquidity creation by the banks and allow banks to survive in the market and evade financial distress.…”

Quality is our asset: The international transmission of liquidity regulation

“…Banks with higher capital ratios might be expected to hold less liquidity if capital and liquidity are substitutes, in line withAcosta-Smith et al (2019) who examine the relationship between capital and liquidity holding for banks in the UK from1988-2013, DeYoung et al (2018 for the US and de Haan and van den End (2013) for the Netherlands.…”

Leverage ratio, risk‐based capital requirements, and risk‐taking in the United Kingdom

“…However, this effect is largely determined by several factors such as competition (González, 2005), bank market power (Agoraki et al., 2011), bank (ex‐ante) riskiness (Klomp & De Haan, 2012), and corporate governance structure (Laeven & Levine, 2009). Some studies have attempted to assess the effects of certain parts of the banking regulatory regime on risk‐taking incentives, such as composition of bank regulatory capital (Fatouh & McCunn, 2022; and Martynova & Perotti, 2018), liquidity requirements (Roulet, 2018), and interactions between liquidity and capital requirements (Acosta‐Smith, 2019). We contribute this strand of the literature by assessing the risk‐taking implications of the leverage ratio as a main component of the post crisis reforms.…”

“…Prior to the introduction of the leverage ratio, the regulatory regime was primarily dominated by the risk‐weighted capital requirements, which induced banks (especially under‐capitalised banks) to restructure their assets towards low‐risk activities which carry low risk weights such as sovereign bonds (Acharya & Steffen, 2015; and Fatouh et al., 2021). As such, there is a growing literature assessing the impact of the leverage ratio on bank behaviour (e.g., Acosta‐Smith, Grill et al., 2020; and Neamtu & Vo, 2021), and especially bank provision of low‐risk activities. Earlier studies (for instance, Baranova et al., 2017; Bicu‐Lieb et al., 2020; Cenedese et al., 2021; Kotidis & Van Horen, 2018; and Noss & Patel, 2019) suggest that the leverage ratio can affect banks’ incentives to engage in low‐risk activities.…”