Bank capital, liquid reserves, and insolvency risk

Julien Hugonnier and Erwan Morellec

Journal of Financial Economics, 2017, vol. 125, issue 2, 266-285

Abstract: We develop a dynamic model of banking to assess the effects of liquidity and leverage requirements on banks’ financing decisions and insolvency risk. In this model, banks face taxation, issuance costs of securities, and default costs and maximize shareholder value by choosing their debt-to-asset ratio, deposits-to-debt ratio, liquid asset holdings, equity issuance and default policies in response to these frictions as well as regulatory requirements. Our analytic characterization of the bank policy choices shows that imposing liquidity requirements leads to lower bank losses in default at the cost of an increased likelihood of default. Combining liquidity and leverage requirements reduces both the likelihood of default and the magnitude of bank losses in default.

Keywords: Banks; Liquidity buffers; Capital structure; Insolvency risk; Regulation (search for similar items in EconPapers)
JEL-codes: G21 G28 G32 G33 (search for similar items in EconPapers)
Date: 2017
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Citations: View citations in EconPapers (45)

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Related works:
Working Paper: Bank Capital, Liquid Reserves, and Insolvency Risk (2015)
Working Paper: Bank Capital, Liquid Reserves, and Insolvency Risk (2014)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jfinec:v:125:y:2017:i:2:p:266-285

DOI: 10.1016/j.jfineco.2017.05.006

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