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Capital and liquidity interaction in banking

Author

Listed:
  • Jonathan Acosta-Smith

    (Bank of England)

  • Guillaume Arnould

    (Bank of England)

  • Kristoffer Milonas

    (Moodys)

  • Quynh-Anh Vo

    (Bank of England)

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.

Suggested Citation

  • Jonathan Acosta-Smith & Guillaume Arnould & Kristoffer Milonas & Quynh-Anh Vo, 2019. "Capital and liquidity interaction in banking," Bank of England working papers 840, Bank of England.
    • Handle: RePEc:boe:boeewp:0840
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    References listed on IDEAS

    as
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    Cited by:

    1. 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.
    2. Ulrich Bindseil & Edoardo Lanari, 2020. "Fire Sales, the LOLR and Bank Runs with Continuous Asset Liquidity," Papers 2010.11030, arXiv.org.
    3. Quynh-Anh Vo, 2021. "Interactions of capital and liquidity requirements: a review of the literature," Bank of England working papers 916, Bank of England.

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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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