Bank Balance Sheet Dynamics Under a Regulatory Liquidity-Coverage-Ratio Constraint

The Basel III standards include a liquidity-coverage-ratio (LCR) constraint that creates an intertemporal link between contemporaneous bank balance-sheet choices and lagged deposits. Assessing the effects of an LCR constraint for banks’ optimal deposit and loan choices requires an intertemporal framework. Our analysis of a dynamic banking model shows that imposing an LCR constraint generally has theoretically ambiguous effects on the stability of banks’ optimal dynamic balance-sheet paths. Even in special cases, such as a situation in which regulators prohibit banks from applying securities to fulfill the LCR constraint or in which banks simultaneously confront risk-based capital regulation while facing rigidities in their equity capital positions, optimal bank deposit paths exhibit increased intertemporal persistence but become more responsive to shocks to market interest rates.