Staff Working Paper No. 840
By Jonathan Acosta-Smith, Guillaume Arnould, Kristoffer Milonas and Quynh-Anh Vo
We study the interaction between banks’ capital and their liquidity transformation in both a theoretical and empirical set-up. We first construct a simple model to develop hypotheses which we test empirically. Using a confidential Bank of England dataset that includes bank-specific capital requirement changes since 1989, we find that banks engage in less liquidity transformation when their capital increases. This finding suggests that capital and liquidity requirements are at least to some extent substitutes. By establishing a robust causal relationship, these results can help guide the optimal joint calibration of capital and liquidity requirements and inform macro-prudential policy decisions.