The European Central Bank published a Working Paper examining how bank capital and liquidity jointly relate to bank stability, using an international sample of 16,061 banks across 27 countries over 2013–2023. The paper finds that higher capital and higher liquidity are each associated with higher stability, but their interaction is negative, consistent with a substitution effect where the marginal stabilising benefit of one buffer falls as the other rises. Bank stability is proxied by the log Z-score, with capital measured as total equity over total assets and liquidity as liquid assets over total assets. Decompositions suggest the main effects operate through the Z-score numerator rather than through lower return volatility. A two-stage analysis using the Lerner index as a measure of market power, instrumented by growth in intangible assets relative to total assets, indicates market power can be a transmission channel, with higher market power associated with lower stability. Results are also reported as varying with bank characteristics (including size, efficiency, business mix and loan growth) and with country characteristics (including institutional quality, rule of law, financial freedom and banking-sector profitability).
European Central Bank 2025-10-07
European Central Bank working paper links higher bank capital and liquidity to greater stability but identifies a substitution effect
The European Central Bank's Working Paper analyzes the relationship between bank capital, liquidity, and stability using data from 16,061 banks across 27 countries from 2013 to 2023. It finds that while higher capital and liquidity individually enhance stability, their interaction shows a substitution effect, reducing the marginal stabilizing benefit. The study also highlights that market power, measured by the Lerner index, can negatively impact stability, with variations based on bank and country characteristics.