Liquidity Regulation and Bank Risk

In this paper, we investigate the impact of liquidity requirements on bank risk. We take advantage of the implementation of the Liquidity Balance Rule (LBR) in the Netherlands in 2003 and analyze its impact on bank default risk. The LBR was imposed on Dutch banks only and did not apply to other banks operating elsewhere within the Eurozone. Using this differential regulatory treatment to overcome identification concerns, we find that following the introduction of the LBR, the risk of Dutch banks declined relatively to counterparts not affected by the rule. Concomitantly, despite the lower cost of funding driven by the LBR, the profitability of Dutch banks decreased in comparison with other banks in Europe, as a result of a decrease in income accruing from interest-bearing activities. Our findings also indicate that relatively to unaffected banks, Dutch banks might not have actively tried to offset their loss in interest income by increasing interest rates of loans. However, better financing conditions allowed Dutch banks to increase the shares of deposits and capital on the liability side of their balance sheets.