Liquidity Regulation and Bank Risk Taking on the Horizon*

This paper examines how banks increase the liquidity of their asset portfolios to comply with tighter liquidity requirements, and how this in turn affects their incentives to take risk with their remaining illiquid assets. We find that U.S. banks subject to the Liquidity Coverage Ratio (LCR) comply with it by reducing illiquid assets rather than by increasing liquid assets. We then develop a simple model to motivate channels by which liquidity risk interacts with credit risk. The model predicts that banks with a greater share of stable liabilities are relatively more likely to engage in risk taking in response to tighter liquidity requirements. This prediction is borne out in transaction-level data from syndicated lending. For identification, we exploit variation in investment in long-term bank bonds by insurance companies that are not affected by the LCR. Our results point to a trade-off in ensuring funding resilience over different horizons.