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 they 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.
