Capital and liquidity interaction in banking

Staff working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 20 December 2019

Staff Working Paper No. 840

By Jonathan Acosta-Smith, Guillaume Arnould, Kristoffer Milonas and Quynh-Anh Vo

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. 

PDFCapital and liquidity interaction in banking

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