The Effect of Liquidity Regulation on U.S. Bank Risk-Taking: Evidence from Reserve Requirements and the Liquidity Coverage Ratio

Abstract

This paper illustrates channels by which regulations that require banks to hold liquid assets can either increase or decrease a bank’s incentive to take risk with its remaining ineligible assets. A greater capacity to respond to liquidity stress increases the potential profits a bank would put at stake by making risky investments, but it also mitigates the illiquidity disadvantages of holding risky assets. We then empirically estimate the effect of two liquidity regulations on bank risk-taking as measured by the ratio of non-performing loans to total loans and credit default swap (CDS) spreads. Using a regression discontinuity design, we do not find evidence that reserve requirements significantly affected non-performing loans ratios. Using a difference- in-differences specification, we also do not find evidence that the liquidity coverage ratio significantly affected non-performing loans ratios or CDS spreads.