DP10378 Bank Capital, Liquid Reserves, and Insolvency Risk
|Author(s):||Julien Hugonnier, Erwan Morellec|
|Publication Date:||February 2015|
|Keyword(s):||banks, capital structure, insolvency risk, liquidity buffers, regulation|
|JEL(s):||G21, G28, G32, G33|
|Programme Areas:||Financial Economics|
|Link to this Page:||cepr.org/active/publications/discussion_papers/dp.php?dpno=10378|
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.