More capital hampers bank’s liquidity creation?

​2 • 2011

The theory of financial intermediation suggests that – in addition to their role in risk transformation – banks also fulfil a function in liquidity creation. Despite this theoretical background and policy interest, however, liquidity creation by banks was not studied empirically until Berger and Bouwman (2009). They developed comprehensive measures of bank liquidity creation, introducing four different measures that take into account alternative classifications of loans and also off-balance-sheet items. A bank creates liquidity if it provides liquid items to the economy and holds illiquid ones. Thus, as an example, liquidity is created when a bank grants loans, but destroyed when it holds cash.
 
Using data for US banks, the authors investigate how much liquidity these banks have created and which banks create the most liquidity. In addition, they also study the role of bank capital in liquidity creation by US banks.
 
The same authors have continued their research by investigating how monetary policy influences bank liquidity creation and if this effect changes in times of financial crisis. Berger, Bouwman, Kick and Schaeck (2010) use German data to study bank liquidity creation and risk taking during distress. Meanwhile, Rauch, Steffen, Hackethal and Tyrell (2009) employ data on German savings banks to study how macroeconomic factors influence liquidity creation by banks.
 
BOFIT is contributing to this strand of the literature by investigating liquidity creation in an emerging market – Russia. Our current research (Zuzana Fungáĉová, Laurent Weill and Mingming Zhou: Bank capital, liquidity creation and deposit insurance, BOFIT DP 17/2010, deals with the relationship between bank capital and liquidity creation, which is particularly important with respect to policy on the setting of bank capital requirements.
 
Two hypotheses largely frame the current discussion of the relationship between bank capital and liquidity creation. The ‘risk absorption’ hypothesis predicts that higher capital will enhance the ability of banks to create liquidity. In contrast, the ‘financial fragility/crowding-out’ hypothesis predicts that greater capital will hamper liquidity creation. Theory further indicates that deposit insurance plays a significant role in the relationship between bank capital and liquidity creation.
 
The introduction of a deposit insurance scheme in an emerging market, Russia, provides a natural experiment to investigate this issue. The authors study three alternative measures of bank liquidity creation and perform estimations on a large set of Russian banks. The findings suggest that the introduction of the deposit insurance scheme exerts a limited impact on the relationship between bank capital and liquidity creation and does not change the negative sign of the relationship. The implication is that better-capitalized banks tend to create less liquidity, which supports the ‘financial fragility/crowding-out’ hypothesis. This conclusion has important policy implications for emerging countries, as it suggests that bank capital requirements implemented to support financial stability may harm liquidity creation.
 
Zuzana Fungáčová
 
References
 
Berger, Allen N. and Bouwman, Christa H. S., Bank Liquidity Creation (September 2009). Review of Financial Studies, Vol. 22, Issue 9, pp. 3779–3837.
 
Berger, Allen N., Bouwman, Christa H. S., Kick, Thomas K. and Schaeck, Klaus, Bank Liquidity Creation and Risk Taking During Distress. Bundesbank Discussion Paper, Series 2: Banking and Financial Studies, No 05/2010.
 
Rauch, Christian, Steffen, Sascha, Hackethal, Andreas and Tyrell, Marcel, Savings Banks, Liquidity Creation and Monetary Policy (February 15, 2009). Available at SSRN: http://ssrn.com/abstract=1343595. 
 

 Zuzana Fungáčová

 
Zuzana Fungáčová