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Our analysis thus suggests that while liquidity requirements can reduce cap- ital injections by the regulator by limiting bank losses in default, they are ineffective at reducing default risk.
The model also allows us to investigate how bank capi- tal structure decisions and default risk depend on a bank's economic environment and asset characteristics.
For ex- ample, we show that an increase in asset risk generally leads to a decrease in the debt-to-asset ratio, an increase in the deposits-to-debt ratio, and an increase in liquid re- serves and default risk.
The literature on default risk in banks started with the early contributions of Merton (1977, 1978), in which the objective is to determine the cost of deposit insurance and loan guarantees.
This prevents an analysis of the joint ef- fects of risky debt financing, liquidity choices, and micro- prudential regulation on default risk, which is the main fo- cus of our paper.
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