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

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  • Passmore, Wayne
  • Temesvary, Judit

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.

Suggested Citation

  • Passmore, Wayne & Temesvary, Judit, 2022. "How investor demands for safety influence bank capital and liquidity trade-offs," Journal of Financial Stability, Elsevier, vol. 60(C).
    • Handle: RePEc:eee:finsta:v:60:y:2022:i:c:s157230892200016x
    DOI: 10.1016/j.jfs.2022.100987
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    More about this item

    Keywords

    Safe assets; Bank liquidity; Liquidity regulation; Capitalization; Bank balance sheet management;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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