September 2020

Investor Demands for Safety, Bank Capital, and Liquidity Measurement

Wayne Passmore and Judit Temesvary

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

DOI: https://doi.org/10.17016/FEDS.2020.079

PDF: Full Paper

Disclaimer: The economic research that is linked from this page represents the views of the authors and does not indicate concurrence either by other members of the Board's staff or by the Board of Governors. The economic research and their conclusions are often preliminary and are circulated to stimulate discussion and critical comment.

The Board values having a staff that conducts research on a wide range of economic topics and that explores a diverse array of perspectives on those topics. The resulting conversations in academia, the economic policy community, and the broader public are important to sharpening our collective thinking.

Back to Top
Last Update: September 18, 2020