Investor Demands for Safety, Bank Capital, and Liquidity Measurement

Wayne Passmore and Judit Temesvary

No 2020-079, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (U.S.)

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. Consistent with our model, our bank-level empirical analysis of these capital-liquidity tradeoffs show (1) that bank liquidity measures have a strong and negative relationship to its capital ratio for both large and small banks, and (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 and 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 (search for similar items in EconPapers)
JEL-codes: G11 G18 G21 G23 G28 (search for similar items in EconPapers)
Pages: 45 p.
Date: 2020-09-18
New Economics Papers: this item is included in nep-ban and nep-rmg
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedgfe:2020-79

DOI: 10.17016/FEDS.2020.079

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