Preferential regulatory treatment and banks’ demand for government bonds

Government bonds receive preferential treatment in financial regulation. The purpose of this paper is to analyze the impact of this preferential treatment on banks’ demand for government bonds. Using unique transaction-level data, our analysis suggests that preferential treatment in liquidity and capital regulation increases banks’ demand for government bonds beyond their own risk appetite. Liquidity and capital regulation also seem to incentivize banks to substitute other bonds with government bonds. On top of that, we find evidence that regulation leads to a longer-term increase in government bond holdings. Finally, our results suggest that higher government bond holdings are associated with more lending and lower profits during normal times but not during stress.
 
Keywords: Government bonds, financial markets, regulation, liquidity, capital.
JEL classification: G18, G21, E42.

Working paper no. 433