September 2020

Investor Demands for Safety, Bank Capital, & Liquidity Measurement

Wayne Passmore & Judit Temesvary

Abstract:

We construct a model of a bank’s optimal funding choice, where the bank negotiates with both safety-driven short-term bondholders & (mostly) risk-taking long-term bondholders. We establish that investor demands for safety create a negative relationship between the bank’s capital choices & short-term funding, as well as negative relationships between capital & common measures of bank liquidity. Consistent with our model, our bank-level empirical analysis of these capital-liquidity tradeoffs show (1) that bank liquidity measures have a strong & negative relationship to its capital ratio for both large & small banks, & (2) that this relationship has weakened with the advent of stronger liquidity regulation. Our results suggest that the safety concerns of bank debt investors may underlie capital-liquidity tradeoffs & that a bank’s share of collateralized short-term debt may be a more robust measure of bank liquidity.

Keywords: Safe assets, Bank Liquidity, Liquidity regulation, capitalization, bank balance sheet management

DOI: https://doi.org/10.17016/FEDS.2020.079

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Last Update:
September 18, 2020