Abstract
This paper discusses the Basel II bank capital regulation in the presence of liquidity risk. Under Basel II, the credit risk taken by banks is evaluated and capital is set to limit, over a one-year horizon, the risk of bank default to a desired confidence level. However, in addition to screening and monitoring borrowers, banks also provide liquidity insurance with the supply of short-term deposits withdrawable on demand. This maturity mismatch creates a second type of risk, the risk of a bank run when new information leads depositors to worry about the value of banks' assets. It is shown, in a stylized Basel II framework, that capital regulation should incorporate a liquidity risk component. In addition, we show that credit risk diversification or a reduced probability of loan default which lead to a reduction of Basel II regulatory capital will increase the probability of a bank run. A leverage ratio which puts a floor on the capital-to-asset ratio is a way to limit such a risk.
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