Bank Liquidity Creation, Monetary Policy, and Financial Crises

Abstract

Monetary policy efficacy depends largely on how it affects bank behavior. Recent events have cast doubt on how well monetary policy works in this regard, particularly during financial crises. In addition, issues have been raised about the role of banks in creating asset bubbles that burst and lead to crises. In this paper, we address these issues by focusing on bank liquidity creation, which is a comprehensive measure of bank output that accounts for all on- and off-balance sheet activities. Specifically, we formulate and test hypotheses that address the following questions: (1) How does monetary policy affect bank liquidity creation during normal times? (2) Does monetary policy affect bank liquidity creation differently during financial crises versus normal times? (3) Is high aggregate bank liquidity creation an indicator of an impending financial crisis? We have three main findings. First, during normal times, monetary policy affects liquidity creation, but only for small banks. Second, the effects of monetary policy are weaker for banks of all sizes during financial crises than during normal times. Third, liquidity creation tends to be high (relative to trend) prior to financial crises and has incremental explanatory power in predicting crises even after controlling for other macroeconomic factors.