How investor demands for safety influence bank capital and liquidity trade-offs

Wayne Passmore and Judit Temesvary

Journal of Financial Stability, 2022, vol. 60, issue C

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.

Keywords: Safe assets; Bank liquidity; Liquidity regulation; Capitalization; Bank balance sheet management (search for similar items in EconPapers)
JEL-codes: G11 G18 G21 G23 G28 (search for similar items in EconPapers)
Date: 2022
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Persistent link: https://EconPapers.repec.org/RePEc:eee:finsta:v:60:y:2022:i:c:s157230892200016x

DOI: 10.1016/j.jfs.2022.100987

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