The theory of financial intermediation highlights various channels through which capital and liquidity are interrelated. Using a simultaneous equations framework, we investigate the relationship between bank regulatory capital buffer and liquidity for European and U.S. publicly traded commercial banks. Previous research studying the determinants of bank capital buffer has neglected the role of liquidity. On the whole, we find that banks do not strengthen their regulatory capital buffer when

more »

... face higher illiquidity as defined in the Basel III accords or when they create more liquidity as measured by Berger and Bouwman (2009) . However, considering other measures of illiquidity that focus more closely on core deposits in the United States, our results show that small banks do actually strengthen their solvency standards when they are exposed to higher illiquidity. Our empirical investigation supports the need to implement minimum liquidity ratios concomitant to capital ratios, as stressed by the Basel Committee; however, our findings also shed light on the need to further clarify how to define and measure illiquidity and also on how to regulate large banking institutions, which behave differently than smaller ones. JEL classification: G21; G28 Electronic copy available at: http://ssrn.com/abstract=2079655 Related literature Our research is related to two strands of literature: the theories linking bank capital and liquidity creation and studies focusing on the determinants of bank capital buffer. Numerous papers deal with the relationship between bank capital and liquidity creation. In their work, Berger and Bouwman (2009) note that two hypotheses largely frame the discussion on this relationship: the "financial fragility/crowding-out" hypothesis and the "risk absorption" hypothesis. Roughly described 5 , the "financial fragility structure" effect is the outcome of the following process. The bank collects funds from depositors and lends them to borrowers. By monitoring borrowers, the bank obtains private information that gives it an advantage in assessing the profitability of its borrowers. However, this informational advantage creates an agency problem, and the bank might extort rents from its depositors by requiring a greater share of the loan income. If depositors refuse to pay the higher cost, the bank withholds monitoring or loan-collecting efforts. Because depositors know that the bank might abuse their trust, they become reluctant to put their money in the bank. Consequently, the bank must win depositors' confidence by adopting a fragile financial structure with a large share of liquid deposits. A contract with depositors mitigates the bank's hold-up problem because depositors can run on the bank if the bank threatens to withhold efforts. Consequently, financial fragility favors liquidity creation in that it allows the bank to collect more deposits and grant more loans. In contrast, higher capital tends to mitigate the financial fragility and enhances the bargaining power of the bank, which hampers the credibility of its commitment to depositors. Thus, higher capital tends to decrease liquidity creation. In addition, Gorton and Winton (2000) show that a higher capital ratio can reduce liquidity creation through another effect: the "crowding-out of deposits". They maintain that deposits are more effective liquidity hedges for agents than investments in bank equity. Indeed, deposits are totally or partially insured and withdrawable at par value. In contrast, bank capital is not exigible and has a stochastic value that depends on the state of bank fundamentals and the liquidity of the stock exchange. Consequently, higher capital ratios shift investors' funds from relatively liquid deposits to relatively illiquid bank capital. Thus, the higher is the bank's capital ratio, the lower is its liquidity creation. Under the second hypothesis, higher capital enhances the ability of banks to create liquidity. Here, liquidity creation increases the bank's exposure to risk, as its losses increase with the level of illiquid 5 See Berger and Bouwman (2009) for a longer discussion on the "financial fragility structure" and the "crowding-out of deposits" effects. (2006), using a sample of UK banks and a large cross-country panel data set from 32 countries, respectively, show that moral hazard is effective and that market discipline encourages banks to strengthen their capital buffer. Fonseca and Gonzalez (2010) consider cross country data from 70 countries and investigate whether the influence of market discipline on capital buffer varies across countries with heterogeneous frameworks for regulation, supervision and institutions. They find that, even if market discipline has a positive impact on bank capital buffer, the relationship depends on several structural factors. Indeed, restrictions on bank activities, effective supervision and bad institutional environment tend to weaken market discipline and reduce incentives for banks to hold capital in excess of the minimum required by regulators. Sample and empirical method Presentation of the sample Our sample includes U.S. and European 6 publicly traded commercial banks over the 2000-2006 period. We deliberately omit the crisis years 2007 and 2008 that are likely to disturb our analysis. We consider U.S. and European banks because the required data are available on standard databases to ensure an accurate representativeness of the sample of banks in each country. Furthermore, we include only listed banks because the setting requires market data (i.e., market value of assets, dividends) and a detailed breakdown of bank balance sheets to compute liquidity indicators. In standard databases, this information is more frequently and extensively reported for listed banks. Annual consolidated financial statements were extracted from Bloomberg. We also consider data from the World Bank's 2007 Regulation and Supervisory Database (Barth et al., 2007) to compute an indicator of regulatory oversight of bank capital. From 2000 to 2006, we identify 870 listed commercial banks (645 in the United States and 225 in Europe). To enable the liquidity indicator computation, we restrict the sample to banks for which the breakdown for loans by category and the breakdown for deposits by maturity were available in Bloomberg or in annual reports. We also delete a bank if its total 6 The sample includes banks from the 27 EU member countries, Norway and Switzerland. However, the required data are available only for banks located in the 20 following countries