DP17811 Banking on the Edge: Liquidity Constraints and Illiquid Asset Risk
We examine how banks' liquidity requirements affect their incentives to take risk with their remaining illiquid assets. Our model predicts that banks with more stable liabilities are more likely to increase risk taking in response to tighter liquidity requirements. This prediction is borne out in transaction-level data on corporate and mortgage loans for U.S. banks subject to the liquidity coverage ratio (LCR). For identification, we exploit variation in long-term bank bonds held by insurance companies that are not affected by the LCR. Our results highlight a trade-off between bank risk taking and simultaneously curbing short-term and long-term liquidity-risk exposures.