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Capital and liquidity interaction in banking

Author

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  • Acosta-Smith, Jonathan
  • Arnould, Guillaume
  • De-Ramon, Sebastian J.A.
  • Milonas, Kristoffer
  • Vo, Quynh-Anh

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.

Suggested Citation

  • Acosta-Smith, Jonathan & Arnould, Guillaume & De-Ramon, Sebastian J.A. & Milonas, Kristoffer & Vo, Quynh-Anh, 2026. "Capital and liquidity interaction in banking," Journal of Financial Stability, Elsevier, vol. 83(C).
    • Handle: RePEc:eee:finsta:v:83:y:2026:i:c:s1572308926000173
    DOI: 10.1016/j.jfs.2026.101515
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    Cited by:

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    2. Chen, Ting-Hsuan & Shen, Chung-Hua & Wu, Meng-Wen & Huang, Kuo-Jui, 2021. "Effect of shadow banking on the relation between capital and liquidity creation," International Review of Economics & Finance, Elsevier, vol. 76(C), pages 166-184.
    3. Ulrich Bindseil & Edoardo Lanari, 2020. "Fire Sales, the LOLR and Bank Runs with Continuous Asset Liquidity," Papers 2010.11030, arXiv.org.
    4. Quynh-Anh Vo, 2021. "Interactions of capital and liquidity requirements: a review of the literature," Bank of England working papers 916, Bank of England.

    More about this item

    Keywords

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    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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