Bank Liquidity, Market Participation, and Economic Growth

Abstract

We report evidence that bank liquidity ratios (liquid assets as a percentage of total assets) decrease during the process of economic development. To reconcile this observation with the increasing importance of financial markets and the increasing direct participation of individual investors in them, we build a neoclassical growth model with banks and markets. In this environment, banks engage in cross-subsidization of the impatient depositors to keep up with the competitive pressure from the markets. Moreover, as the economy grows, it becomes easier for the individuals to access the market, and the banks react to this by lowering their liquidity ratios. In a panel of 45 countries, we find evidence that such a mechanism is into place: a one-unit increase in an index of securities market liberalization leads to a drop in the bank liquidity ratio between 15 and 22 per cent.