Bank Capital, Liquid Reserves, and Insolvency Risk

We develop a dynamic model of banking to assess the effects of liquidity and capital 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 and are financed with equity, insured deposits, and risky debt. Using the model, we demonstrate that (i ) regulatory requirements affect bank behaviour even when they are not binding; (ii ) liquidity requirements constraining banks to hold a minimum amount of liquid reserves have no long-run effects on default risk but may increase default risk in the short run; (iii ) capital requirements increase banks' franchise value ex post and reduce default risk; (iv ) levered banks have no risk shifting incentives when outside financing is costly.

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