Bank balance sheet dynamics under a regulatory liquidity-coverage-ratio constraint

• We examine a bank’s dynamic choices under a binding liquidity-coverage ratio (LCR) constraint.
• Our baseline balance-sheet dynamics starts with portfolio separation and no LCR constraint.
• Effects of an LCR constraint on dynamic deposit and loan paths depend on several factors.
• Balance-sheet dynamics are complicated if banks can apply securities to satisfy the LCR 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.