The Joint Impact of Bank Capital and Funding Liquidity on the Monetary Policy's Risk-Taking Channel: A Bird's Eye View from the Euro Area Early Days

Abstract

Despite an extensive literature on the risk–taking channel of monetary policy, the joint impact of bank capital and on the latter remains poorly documented. Yet that prospect is essential for monetary policy taking action under the Basel III framework involving concomitant capital and funding liquidity standards. Using data on euro area from 1999 to 2018 and triple interactions between monetary policy, equity and funding liquidity, we shed light on a crowding–out of deposits effect prior to the 2008 GFC which supports the need for simultaneous capital and funding liquidity ratios to mitigate the monetary transmission to bank credit risk. Interestingly, our findings also highlight a missing crowding–out of deposits effect amongst poorly efficient banks in the aftermath of the GFC. As a result, a trade-off arises between financial stability and increased funding liquidity for these financial intermediaries, making a special treatment required for inefficient banks operating in a low interest rate environment. These results challenge the implementation of uniform funding liquidity requirements across the euro area.