Capital and liquidity interaction in banking
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Capital and liquidity interaction in banking
BANK OF ENGLANDStaff Working Paper No. 840Capital and liquidity interaction in bankingJonathan Acosta-Smith, Guillaume Arnould,Kristoffer Milonas and Capital and liquidity interaction in banking Quynh-Anh Vo43983This Is an updated version of the Staff Working Paper originally published on 20 December 2019Staff Working Papers describe research in progress by the author(s) and are published to ekit comments and to further debate Any views expressed are solely those of the author(s) and so ca Capital and liquidity interaction in banking nnot be taken to represent those of the Bank of England or to state Bank of England policy. This paper should therefore not be reported as representinCapital and liquidity interaction in banking
g the views of the Bank of England or members of the Monetary Policy Committee, Financial Poky Committee or Prudential Regulation Committeehttps://khoBANK OF ENGLANDStaff Working Paper No. 840Capital and liquidity interaction in bankingJonathan Acosta-Smith, Guillaume Arnould,Kristoffer Milonas and Capital and liquidity interaction in banking ristoffer Milonas(3) and Quynh-Anh Vo(4)AbstractWe study how banks' capital level affects the extent to which they engage in liquidity transformation. We first construct a simple model to develop testable hypotheses on this link. Then we test our predictions and establish the causality using a confi Capital and liquidity interaction in banking dential Bank of England dataset that includes arguably exogenous changes in banks' capital requirement add-ons. We find that banks engage in less liquCapital and liquidity interaction in banking
idity transformation when their capital increases, which suggests that capital and liquidity requirements are at least to some extent substitutes. We BANK OF ENGLANDStaff Working Paper No. 840Capital and liquidity interaction in bankingJonathan Acosta-Smith, Guillaume Arnould,Kristoffer Milonas and Capital and liquidity interaction in banking ital and liquidity requirements and for the proportionality of prudential regulations.Key words: Banking, liquidity transformation, capital requirements and financial regulation.JEL classification: G21, G28, G32.-1Rank of England. Email: jonathan.smith@bankofengland.co.uk-2Bank of England. Email: gu Capital and liquidity interaction in banking illaume.amould@bankofcngland.co.uk(.3) Moody's Analytics, rmail: kristoffer.milonasi&mocdys.com(4) Bank of England. Email: quynh arih.vo@bankofenglandCapital and liquidity interaction in banking
.co.ukWe are grateful tor helpful comments from Kartik Anand (discussant), Ihorsten Reck, Stephen Cecchetti, Rill Francis, Iflekhar Hasan, Renata HerrBANK OF ENGLANDStaff Working Paper No. 840Capital and liquidity interaction in bankingJonathan Acosta-Smith, Guillaume Arnould,Kristoffer Milonas and Capital and liquidity interaction in banking der Ghote (discussant), Matthew Willison and participants at the 2020 federal Reserve System Day Ahead Conference in San Diego, US; the European System of Central Banks' (ESCB) Day Ahead Conference 2019 in Lisbon. Portugal; EEA 2019 in Manchester. UK; 2019 BCBS RI E CEPR join Workshop in Basel. Swit Capital and liquidity interaction in banking zerland; EEMA2019 in Azores, Portugal; IBrrA-WEAl 2019 conference in San Francisco, US; Global TMA 2019 conference in Bogota, Colombia; EEBS 2019 annuCapital and liquidity interaction in banking
al conference in Prague, Czech Republic; RES 2019 annual conference in Warwick. UK; INHNI112018 conference in Poznan. Poland; and IEABS 2018 conferencBANK OF ENGLANDStaff Working Paper No. 840Capital and liquidity interaction in bankingJonathan Acosta-Smith, Guillaume Arnould,Kristoffer Milonas and Capital and liquidity interaction in banking Sebastian de-Ramon for invaluable data guidance and helpful comments. Casey Murphy and Philip Massoud provided valuable research assistance. I he views expressed in this paper are those of the authors, and not necessarily those of the Rank of England. Milonas' contribution to this paper was mainly Capital and liquidity interaction in banking earned out when he was employed by the Rank of England. The views expressed herein are solely those of the author and do not represent the views of hiCapital and liquidity interaction in banking
s employer, Moody's Analytics, its parent company (Moody's Corporation) or its affiliates.rhe Bank's working paper scries can be found at www.bankofenBANK OF ENGLANDStaff Working Paper No. 840Capital and liquidity interaction in bankingJonathan Acosta-Smith, Guillaume Arnould,Kristoffer Milonas and Capital and liquidity interaction in banking England 2020 ISSN 1749-9135 (on-line)1 IntroductionLiquidity played an enormous role in the global financial crisis 2007 - 2009. Many banks experienced difficulties largely because they had not managed their liquidity positions in a prudent manner. In response to this, the Basel Committee on Banking Capital and liquidity interaction in banking Supervision (BCBS) proposed new regulatory liquidity standards to complement the revised capital requirements. Whereas the goal of capital regulationCapital and liquidity interaction in banking
s is to improve bank solvency, liquidity requirements aim to prevent banks from aggressively engaging in liquidity transformation, which can expose thBANK OF ENGLANDStaff Working Paper No. 840Capital and liquidity interaction in bankingJonathan Acosta-Smith, Guillaume Arnould,Kristoffer Milonas and Capital and liquidity interaction in banking questions on how the two regulations interact and how they could be jointly designed. Policy maker, therefore could benefit from understanding the interaction between banks’ capital and their liquidity decisions.In this paper, we aim to shed light on these questions by examining how a bank’s capita Capital and liquidity interaction in banking l level affects its incentives to engage in liquidity transformation. Answering this question helps to understand whether actions leading to changes iCapital and liquidity interaction in banking
n bank capital can produce similar effects on the resilience of a bank s liquidity risk profile as changes in liquidity requirements can. This in turnBANK OF ENGLANDStaff Working Paper No. 840Capital and liquidity interaction in bankingJonathan Acosta-Smith, Guillaume Arnould,Kristoffer Milonas and Capital and liquidity interaction in banking es or decreases the returns on tightening liquidity requirements.We tackle the question by building both theoretical and empirical evidence. Our simple theoretical banking model clarifies potential channels for the impact of bank capital on bank liquidity and helps develop hypotheses. These predicti Capital and liquidity interaction in banking ons are then taken to the data. In our theoretical setting, banks are featured as intermediaries that provide liquidity to their customers, which in tCapital and liquidity interaction in banking
urn exposes them to funding liquidity risk. Banks manage this risk by maintaining a stock of liquid assets. 1 he model focuses on analysing how banks’BANK OF ENGLANDStaff Working Paper No. 840Capital and liquidity interaction in bankingJonathan Acosta-Smith, Guillaume Arnould,Kristoffer Milonas and Capital and liquidity interaction in banking wo theoretical predictions about the effects of banks' capital on their asset liquidity and on their overall degree of liquidity transformation. Our empirical assessment tests these predictions by exploiting arguably exogenous changes in capital requirements imposed by L K supervisors on banks3in UK Capital and liquidity interaction in banking .Our contribution is twofold. First, tile two-pronged approach provides a solid theoretical underpinning for our empirical tests and their interpretatCapital and liquidity interaction in banking
ion. Our theoretical setup, although simple, captures a key source of banks’ exposure to liquidity risk, namely liquidity provision. It clarifies two BANK OF ENGLANDStaff Working Paper No. 840Capital and liquidity interaction in bankingJonathan Acosta-Smith, Guillaume Arnould,Kristoffer Milonas and Capital and liquidity interaction in banking more stable liability structure, which in turn implies a lower need for liquidity holdings and so induces banks to hold less liquid assets -effect. Second, ahigher capital ratio leads to a higher cost of early liquidation due to insufficient liquidity holdings - "skin-in-the-game” effect. This indu Capital and liquidity interaction in banking ces banks to hold more liquidity. These two effects trade-off each other, so the overall effect depends on which of rhe two effects is stronger. In teCapital and liquidity interaction in banking
rms of how a bank's capital impacts its overall liquidity transformation, this impact depends on the relative strength of the effects on its asset liqBANK OF ENGLANDStaff Working Paper No. 840Capital and liquidity interaction in bankingJonathan Acosta-Smith, Guillaume Arnould,Kristoffer Milonas and Capital and liquidity interaction in banking ted U-shape, while with respect to liquidity transformation, a higher capital ratio will monotonically lead to a lower degree of liquidity transformation.Our second contribution lies in our strategy to establish causation in the link between bank capital and bank liquidity. Since ill practice, both Capital and liquidity interaction in banking may be jointly determined, endogeneity is one of the main challenges for our empirical analysis of the relationship between them. In a fairly limitedCapital and liquidity interaction in banking
literature on this relationship, some papers have resorted to mainly making correlational claims instead of causal ones, while others have attempted tBANK OF ENGLANDStaff Working Paper No. 840Capital and liquidity interaction in bankingJonathan Acosta-Smith, Guillaume Arnould,Kristoffer Milonas and Capital and liquidity interaction in banking 13). Our identification Strategy instead uses bank-level regulatory capital add-ons imposed by UK supervisors to banks in the UK. Changes in these add-ons can be claimed to be exogenous to a bank’s liquidity profile. The reason for such exogeneity is that when setting those add-ons. as highlighted i Capital and liquidity interaction in banking n Tiirner Review (2009). UK supervisors focus on organisational structures, systems and reporting procedures rather than financial risks of banks.OurCapital and liquidity interaction in banking
empirical methodology is thus to regress measures of bank liquidity on banks’ required capital ratios. To measure banks' asset liquidity, we use the sGọi ngay
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