Bank asset structure and the risk-taking implications of capital and liquidity requirements

Abstract

In addition to risky loans, banks hold risky securities that provide uncertain future liquidity. This leads them to choose an asset structure with their desired correlation between liquidity and long term asset returns. We show that liquidity management and risk management concerns lead to a trade-off that creates an inverse relationship between security holdings and aggregate asset risk. Capital requirements mitigate liquidity risk in all future states of the world, thereby reducing the cost of liquidity risk and leading banks to increase aggregate asset risk. Liquidity requirements such as the Liquidity Coverage Ratio (LCR) affect high liquidity shock states and mitigate aggregate asset risk-taking. These results highlight the tension between capital and liquidity regulations in addressing the risk taking incentives of financial intermediaries.

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