Determinants of banks’ liquidity: A French perspective on interactions between market and regulatory requirements

Abstract

Abstract The paper investigates the impact of solvency and liquidity regulation as well as market shocks on banks’ balance sheet structure. It contributes in particular to the debate on the use of liquidity buffers by banks, as initiated by Goodhart’s (2008), “last taxi” argument. The volatility of long-term markets observed during the Covid-19 pandemic shows that periods of sharp increase in risk aversion still result in liquidity strains for banks. The latter react differently depending on the diversity of their funding sources and their risk profile. Indeed, during a crisis, due to interactions between funding and market liquidity, as well as regulatory constraints, one may wonder whether banks may increase or decrease liquidity. According to a simple portfolio allocation model banks’ liquidity increases when the regulatory constraint is binding, as banks hoard extra liquidity, while they do not if the regulatory constraint is not binding. We show that in times of crisis, measured by large deviations of a financial variable capturing international markets’ risk aversion, French banks actually decreased the liquidity coefficient, with our results mostly driven by less liquid banks. However, while we do find that the solvency ratio has a weakly significant effect on the liquidity coefficient, we were not able to establish a firm causal relationship between the two variables on the basis of Granger causality tests.