Interconnection between Banking Capital and Liquidity after Basel III: an empirical analysis on European Banks

Basel III introduced significant regulatory changes in the banking sector in response to the disruptions caused by the 2008 Great Financial Crisis. Among them, a key role is played by the strengthened capital requirements and the newly introduced liquidity standards. These changes raise questions about how capital and liquidity requirements interact and how they should be jointly addressed. The primary aim of this thesis is to improve the understanding of this relationship and to enrich the existing literature by investigating heterogeneity across banks of different sizes. Using an unbalanced panel covering 69 European banks subject to the EBA stress test over 12 quarters, I employ Random Effects (RE) models to analyse the interaction between regulatory capital and liquidity. The results highlight differential approaches across bank sizes. For medium-sized banks, the two layers of stability are found to positively co-move, suggesting that a contraction in one dimension can propagate to the other. This finding is consistent with the Basel Committee’s view that stringent regulations on capital and liquidity should be imposed simultaneously. For large banks, instead, no significant relationship emerges, suggesting independence between the two layers, likely due to more sophisticated and separate risk management practices. Given the lack of evidence of a substitutive relationship between capital and liquidity, even for large banks, simultaneous regulation remains justified, although arguably less imperative. Overall, the findings empirically support the Basel III framework and the introduction of minimum liquidity requirements alongside capital ones to promote the financial stability of banking institutions.