Working Paper: CEPR ID: DP10378
Authors: Julien Hugonnier; Erwan Morellec
Abstract: We develop a dynamic model to assess the effects of liquidity and leverage requirements on banks' insolvency risk. The model features endogenous capital structure, liquid asset holdings, payout, and default decisions. In the model, banks face taxation, flotation costs of securities, and default costs. They are financed with equity, insured deposits, and risky debt. Using the model, we show that liquidity requirements have no long-run effects on default risk but may increase it in the short-run; leverage requirements reduce default risk but may significantly reduce bank value; mispriced deposit insurance fuels default risk while depositor preference in default decreases it.
Keywords: banks; capital structure; insolvency risk; liquidity buffers; regulation
JEL Codes: G21; G28; G32; G33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| liquidity requirements (E41) | default risk (G33) |
| liquidity requirements (E41) | insolvency risk (G33) |
| banks' response to liquidity requirements (G21) | target level of liquid reserves (G33) |
| target level of liquid reserves (G33) | bank value (G21) |
| liquidity requirements (E41) | banks' behavior (G21) |
| leverage requirements (G32) | default risk (G33) |
| increasing equity capital (O16) | default probability (C46) |
| increasing equity capital (O16) | bank value (G21) |
| mispriced deposit insurance (G28) | insolvency risk (G33) |
| depositor preference in default (G33) | conservative financing policies (E62) |
| conservative financing policies (E62) | insolvency risk (G33) |