Bank liquidity creation, monetary policy, and financial crises

Abstract

This paper examines the interplay among bank liquidity creation (which incorporates all bank on- and off-balance sheet activities), monetary policy, and financial crises. We find that: (1) high liquidity creation (relative to trend) – particularly off-balance sheet liquidity creation – helps predict crises, controlling for other factors; (2) monetary policy has statistically significant, but economically minor effects on liquidity creation by small banks during normal times, and these effects are even weaker during financial crises; (3) monetary policy has very little effects on medium and large bank liquidity creation during both normal times and crises. These findings suggest that authorities may wish to monitor bank liquidity creation closely in order to predict and perhaps lessen the likelihood of financial crises. They might also consider other tools to control bank liquidity creation, such as capital and liquidity requirements.