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Bank Liquidity Creation

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Bank Liquidity Creation

Allen N Berger and Christa H S Bouwman

The modern theory of financial intermediation suggests that the central role of banks in economy is to create liquidity and transform risk. These theories argue that banks create liquidity on the balance sheet by financing relatively illiquid assets with relatively liquid liabilities. According to the risk transformation theories, banks transform risk by issuing riskless deposits to finance risky loans.

This paper develops four comprehensive measures of bank liquidity creation that differ in how off balance sheet activities are treated and how loans are classified. Then the study explores how much liquidity banks create, how liquidity creation has changed over time, how it varies in the cross-section, which banks create the most and least liquidity, and how liquidity creation is related to bank value.

These questions are examined by applying the liquidity creation measures to data on virtually all U.S. banks over 1993-2003, by splitting the data in various ways (by bank size, bank holding company status, wholesale versus retail orientation, and merger status), by contrasting the top 25% and bottom 25% of liquidity creators in each size class, and by examining correlations between liquidity creation and bank value. Another goal is to use the liquidity creation measures to examine the effect of the bank capital on bank liquidity creation.

For the construction of liquidity measures, all bank assets, liabilities, equity and off balance sheet activities are classified as liquid, semi liquid or illiquid and then assigned weights. The liquidity creation measures are based on four combinations of variables of category & off balance sheet activities, maturity & off balance sheet activities, category & exclusion of off balance sheet activities, maturity & exclusion of off balance sheet activities.

The study regresses the dollar amount of bank liquidity creation (calculated using the four liquidity creation measures) divided by bank gross total assets on the lagged equity capital ratio while controlling for other factors that may affect bank liquidity creation. The control variables include bank risk, bank size, merger and acquisition history, and local market competition and economic environment. The key exogenous variable is the lagged capital ratio.

The US banking industry created  $2.843 trillion in liquidity in 2003 using the preferred category & off balance sheet activities measure. The bank liquidity creation equals 70% of gross loans and 58% of total deposits. On the basis of combination of category & off balance sheet activities measure criterion, large banks are responsible for 85% of industry liquidity creation, while comprising only 5% of the sample observations. Banks that are members of a multibank holding company, have a retail orientation, and engaged in M&A activity during the prior three years created most of the banking industry’s overall liquidity. These banks also showed the strongest growth in liquidity creation over time.

The results suggest that banks and bank holding companies that create more liquidity have significantly higher market-to-book and price-earnings ratios. For large banks, the relationship between capital and liquidity creation is slightly positive, consistent with the expected empirical dominance of the “risk absorption” effect. In sharp contrast, for small banks, the relationship between capital and liquidity creation is negative, consistent with the expected dominance of the “financial fragility-crowding out” effect for these institutions (a more fragile capital structure encourages the bank to commit to monitoring its borrowers, and allows it to extend loans).



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