Journal of Financial Stability Vol. 60 2022
How investor demands for safety influence bank capital and liquidity trade-offs
Abstract
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.
- DOI
- 10.1016/j.jfs.2022.100987
- Volume
- 60
- Pages
- 100987
- Language
- en
- Sources
- bibtex:phds-export.bib openalex crossref