Bank Liquidity and the Cost of Debt

Abstract

Since the 2007–09 crisis, tougher bank liquidity regulation has been imposed which aims to ensure banks can survive a severe funding stress. Critics of this regulation suggest that it raises the cost of maturity transformation and reduces productive lending. In this paper we build a bank run model with a unique equilibrium where solvent banks can fail due to illiquidity. We endogenise banks’ funding costs as a function of their liquid asset holdings and show how they are negatively related to liquidity, therefore offsetting some of the costs from higher liquidity requirements. We find evidence for this relationship using post-crisis data for US banks, implying that liquidity requirements may be less costly than previously thought.