Bank Capital, Liquid Reserves, and Insolvency Risk

Julien Hugonnier and Erwan Morellec
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Erwan Morellec: Ecole Polytechnique Fédérale de Lausanne; Swiss Finance Institute

No 14-70, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: We develop a dynamic model of banking to assess the effects of liquidity and leverage requirements on banks' insolvency risk. In this model, banks face taxation, flotation costs of securities, and default costs and maximize shareholder value by making their financing, liquid asset holdings, and default decisions in response to these frictions as well as regulatory requirements. Our analytic characterization of the bank policy choices shows that imposing solely liquidity requirements leads to lower bank losses in default at the cost of an increased likelihood of default. Combining liquidity requirements with leverage requirements reduces drastically 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)
Pages: 44 pages
Date: 2014-06
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Citations: View citations in EconPapers (3)

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Related works:
Journal Article: Bank capital, liquid reserves, and insolvency risk (2017)
Working Paper: Bank Capital, Liquid Reserves, and Insolvency Risk (2015)
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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp1470

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