Bank Liquidity Standards: A Microeconomic Analysis

Full paper available here.

William Perraudin and Peng Yang

This paper formulates a simulation model of a bank balance sheet and analyses optimal choices of portfolio credit quality and funding maturity under different assumptions about liquid assets requirements that may be imposed by regulators. We employ industry standard approaches to modelling portfolio payoffs. Funding costs are assumed to rise if impairment in asset quality generates a decline in the bank’s rating. We parameterise the model to be consistent with balance sheet data for two large UK banks at end 2009.

We examine the impacts on bank asset-liability choices of the two liquidity standards proposed by BCBS (2009): (i) a requirement that banks hold sufficient liquid assets to survive a funding stress scenario designed by regulators and (ii) a requirement that bank liabilities weighted according to their relative stability exceed assets weighted according to their relative illiquidity. (ii) represents a potential constraint on bank asset-liability choices whereas (i) consists of a bank specific requirement to hold liquid assets at no lower than a given level.

According to our calculations, the constraint in (ii) does not bind for the two banks we examine. We model (i) as an exogenous upward shift from current levels in liquid asset holdings. Both banks we examine held liquid assets at around 7% at end 2009. We experiment by raising the liquid asset requirement in (i) to 10% and 12.5% of assets. For both banks, the effect is to increase the short-term funding and bank employs and to induce it to hold more risky assets.