We construct a model of a bank’s optimal funding choice, where the bank negotiates with both safety-driven short-term bondholders and (mostly) risk-taking long-term bondholders. We establish that investor demands for safety create a negative relationship between the bank’s capital choices and short-term funding, as well as negative relationships between capital and common measures of bank liquidity. Short-term investors’ demands for safety force the bank to hold more collateral, which diminishes the demands by long-term bondholders for higher holdings of bank capital. Consistent with our model, our bank-level empirical analysis of these capital–liquidity trade-offs shows that bank liquidity measures have a strong and negative relationship to the capital ratio. Furthermore, we show that this trade-off does not appear to be regulation related and has diminished in size over time.

This paper examines how the lending of all foreign banks (branches and subsidiaries) in the US responds to foreign monetary policy actions in their parents’ home countries. Using a rarely studied bank-level dataset covering US-based foreign bank offices over the 1997–2014 period, I find strong evidence of a bank lending channel of inward monetary policy transmission: In response to home country monetary tightening, foreign banks with less access to liquid funds reduce their business lending in the US substantially more than foreign banks with more funding access. This inward transmission is strongest for the pre-crisis period, and for foreign banks originating from Europe.